Macroeconomic Theory and Policy

Macroeconomic Theory and
Policy
Preliminary Draft
David Andolfatto
Simon Fraser University
[email protected]
c August 2005
°
ii
Contents
Preface ix
I Macroeconomic Theory: Basics 1

1 The Gross Domestic Product 3
1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.2 How GDP is Calculated . . . . . . . . . . . . . . . . . . . . . . . 5
1.2.1 The Income Approach . . . . . . . . . . . . . . . . . . . . 5
1.2.2 The Expenditure Approach . . . . . . . . . . . . . . . . . 6
1.2.3 The Income-Expenditure Identity . . . . . . . . . . . . . . 7
1.3 What GDP Does Not Measure . . . . . . . . . . . . . . . . . . . 8
1.4 Nominal versus Real GDP . . . . . . . . . . . . . . . . . . . . . . 9
1.5 Real GDP Across Time . . . . . . . . . . . . . . . . . . . . . . . 12
1.6 Schools of Thought . . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.7 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
1.8 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
1.A Measured GDP: Some Caveats . . . . . . . . . . . . . . . . . . . 18
2 Basic Neoclassical Theory 21

2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
2.2 The Basic Model . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
2.2.1 The Household Sector . . . . . . . . . . . . . . . . . . . . 23
2.2.2 The Business Sector . . . . . . . . . . . . . . . . . . . . . 30
2.2.3 General Equilibrium . . . . . . . . . . . . . . . . . . . . . 31
2.3 Real Business Cycles . . . . . . . . . . . . . . . . . . . . . . . . . 35
2.3.1 The Wage Composition Bias . . . . . . . . . . . . . . . . 38
2.4 Policy Implications . . . . . . . . . . . . . . . . . . . . . . . . . . 39
2.5 Uncertainty and Rational Expectations . . . . . . . . . . . . . . . 41
2.6 Animal Spirits . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
2.6.1 Irrational Expectations . . . . . . . . . . . . . . . . . . . 43
2.6.2 Self-Fulfilling Prophesies . . . . . . . . . . . . . . . . . . . 44
2.7 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
2.8 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
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2.9 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
2.A A Model with Capital and Labor . . . . . . . . . . . . . . . . . . 50
2.B Schumpeter’s Process of Creative Destruction . . . . . . . . . . . 53
3 Fiscal Policy 55
3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
3.2 Government Purchases . . . . . . . . . . . . . . . . . . . . . . . . 55
3.2.1 Lump-Sum Taxes . . . . . . . . . . . . . . . . . . . . . . . 56
3.2.2 Distortionary Taxation . . . . . . . . . . . . . . . . . . . . 59
3.3 Government and Redistribution . . . . . . . . . . . . . . . . . . . 60
3.4 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
4 Consumption and Saving 67

4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
4.2 A Two-Period Endowment Economy . . . . . . . . . . . . . . . . 68
4.2.1 Preferences . . . . . . . . . . . . . . . . . . . . . . . . . . 68
4.2.2 Constraints . . . . . . . . . . . . . . . . . . . . . . . . . . 69
4.2.3 Robinson Crusoe . . . . . . . . . . . . . . . . . . . . . . . 70
4.2.4 Introducing a Financial Market . . . . . . . . . . . . . . . 71
4.2.5 Individual Choice with Access to a Financial Market . . . 74
4.2.6 Small Open Economy Interpretation . . . . . . . . . . . . 76
4.3 Experiments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
4.3.1 A Transitory Increase in Current GDP . . . . . . . . . . . 77
4.3.2 An Anticipated Increase in Future GDP . . . . . . . . . . 79
4.3.3 A Permanent Increase in GDP . . . . . . . . . . . . . . . 82
4.3.4 A Change in the Interest Rate . . . . . . . . . . . . . . . 84
4.4 Borrowing Constraints . . . . . . . . . . . . . . . . . . . . . . . . 86
4.5 Determination of the Real Interest Rate . . . . . . . . . . . . . . 89
4.5.1 General Equilibrium in a 2-Period Endowment Economy . 90
4.5.2 A Transitory Decline in World GDP . . . . . . . . . . . . 92
4.5.3 A Persistent Decline in World GDP . . . . . . . . . . . . 93
4.5.4 Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
4.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
4.7 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
4.8 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
4.A Alexander Hamilton on Repaying the U.S. War Debt . . . . . . . 103
4.B Milton Friedman Meets John Maynard Keynes . . . . . . . . . . 104
4.C The Term Structure of Interest Rates . . . . . . . . . . . . . . . . 106
4.D The Intertemporal Substitution of Labor Hypothesis . . . . . . . 108
5 Government Spending and Finance 111

5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
5.2 The Government Budget Constraint . . . . . . . . . . . . . . . . 111
5.3 The Household Sector . . . . . . . . . . . . . . . . . . . . . . . . 113
5.4 The Ricardian Equivalence Theorem . . . . . . . . . . . . . . . . 114
5.5 Government Spending . . . . . . . . . . . . . . . . . . . . . . . . 117
CONTENTS v
5.5.1 A Transitory Increase in Government Spending . . . . . . 118

5.6 Government Spending and Taxation in a Model with Production 119
5.6.1 Ricardian Equivalence . . . . . . . . . . . . . . . . . . . . 120
5.6.2 Government Spending Shocks . . . . . . . . . . . . . . . . 121
5.6.3 Barro’s Tax-Smoothing Argument . . . . . . . . . . . . . 121
5.7 U.S. Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
5.8 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123
5.9 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124
5.10 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
6 Capital and Investment 127

6.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
6.2 Capital and Intertemporal Production . . . . . . . . . . . . . . . 128
6.3 Robinson Crusoe . . . . . . . . . . . . . . . . . . . . . . . . . . . 130
6.4 A Small Open Economy . . . . . . . . . . . . . . . . . . . . . . . 133
6.4.1 Stage 1: Maximizing Wealth . . . . . . . . . . . . . . . . 133
6.4.2 Stage 2: Maximizing Utility . . . . . . . . . . . . . . . . . 136
6.4.3 A Transitory Productivity Shock . . . . . . . . . . . . . . 138
6.4.4 A Persistent Productivity Shock . . . . . . . . . . . . . . 140
6.4.5 Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
6.5 Determination of the Real Interest Rate . . . . . . . . . . . . . . 142
6.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
6.7 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
6.8 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
7 Labor Market Flows and Unemployment 147

7.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147
7.2 Transitions Into and Out of Employment . . . . . . . . . . . . . 147
7.2.1 A Model of Employment Transitions . . . . . . . . . . . . 149
7.3 Unemployment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
7.3.1 A Model of Unemployment . . . . . . . . . . . . . . . . . 155
7.3.2 Government Policy . . . . . . . . . . . . . . . . . . . . . . 158
7.4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
7.5 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
7.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
7.A A Dynamic Model of Unemployment . . . . . . . . . . . . . . . . 161
II Macroeconomic Theory: Money 165

8 Money, Interest, and Prices 167
8.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
8.2 What is Money? . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
8.3 Private Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
8.3.1 The Neoclassical Model . . . . . . . . . . . . . . . . . . . 169
8.3.2 Wicksell’s Triangle: Is Evil the Root of All Money? . . . . 170
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8.3.3 Government Money . . . . . . . . . . . . . . . . . . . . . 173

8.4 The Quantity Theory of Money . . . . . . . . . . . . . . . . . . . 173
8.5 The Nominal Interest Rate . . . . . . . . . . . . . . . . . . . . . 177
8.5.1 The Fisher Equation . . . . . . . . . . . . . . . . . . . . . 179
8.6 A Rate of Return Dominance Puzzle . . . . . . . . . . . . . . . . 181
8.6.1 The Friedman Rule . . . . . . . . . . . . . . . . . . . . . . 183
8.7 Inflation Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . 184
8.8 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
8.9 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
8.10 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
9 The New-Keynesian View 189

9.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189
9.2 Money Non-Neutrality . . . . . . . . . . . . . . . . . . . . . . . . 189
9.2.1 A Basic Neoclassical Model . . . . . . . . . . . . . . . . . 190
9.2.2 A Basic Keynesian Model . . . . . . . . . . . . . . . . . . 191
9.3 The IS-LM-FE Model . . . . . . . . . . . . . . . . . . . . . . . . 193
9.3.1 The FE Curve . . . . . . . . . . . . . . . . . . . . . . . . 193
9.3.2 The IS Curve . . . . . . . . . . . . . . . . . . . . . . . . . 194
9.3.3 The LM Curve . . . . . . . . . . . . . . . . . . . . . . . . 195
9.3.4 Response to a Money Supply Shock: Neoclassical Model . 195
9.3.5 Response to a Money Supply Shock: Keynesian Model . . 197
9.4 How Central Bankers View the World . . . . . . . . . . . . . . . 199
9.4.1 Potential Output . . . . . . . . . . . . . . . . . . . . . . . 199
9.4.2 The IS and SRFE Curves . . . . . . . . . . . . . . . . . . 201
9.4.3 The Phillips Curve . . . . . . . . . . . . . . . . . . . . . . 201
9.4.4 Monetary Policy: The Taylor Rule . . . . . . . . . . . . . 203
9.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205
9.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
9.A Are Nominal Prices/Wages Sticky? . . . . . . . . . . . . . . . . . 207
10 The Demand for Fiat Money 209

10.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
10.2 A Simple OLG Model . . . . . . . . . . . . . . . . . . . . . . . . 210
10.2.1 Pareto Optimal Allocation . . . . . . . . . . . . . . . . . . 211
10.2.2 Monetary Equilibrium . . . . . . . . . . . . . . . . . . . . 213
10.3 Government Spending and Monetary Finance . . . . . . . . . . . 217
10.3.1 The Inflation Tax and the Limit to Seigniorage . . . . . . 219
10.3.2 The Inefficiency of Inflationary Finance . . . . . . . . . . 222
10.4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
10.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
CONTENTS vii
11 International Monetary Systems 227

11.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
11.2 Nominal Exchange Rate Determination: Free Markets . . . . . . 229
11.2.1 Understanding Nominal Exchange Rate Indeterminacy . . 231
11.2.2 A Multilateral Fixed Exchange Rate Regime . . . . . . . 233
11.2.3 Speculative Attacks . . . . . . . . . . . . . . . . . . . . . 236
11.2.4 Currency Union . . . . . . . . . . . . . . . . . . . . . . . 239
11.2.5 Dollarization . . . . . . . . . . . . . . . . . . . . . . . . . 239
11.3 Nominal Exchange Rate Determination: Legal Restrictions . . . 240
11.3.1 Fixing the Exchange Rate Unilaterally . . . . . . . . . . . 242
11.4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
11.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
11.A Nominal Exchange Rate Indeterminacy and Sunspots . . . . . . 245
11.B International Currency Traders . . . . . . . . . . . . . . . . . . . 247
11.C The Asian Financial Crisis . . . . . . . . . . . . . . . . . . . . . . 248
12 Money, Capital and Banking 251

12.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251
12.2 A Model with Money and Capital . . . . . . . . . . . . . . . . . . 251
12.2.1 The Tobin Effect . . . . . . . . . . . . . . . . . . . . . . . 254
12.3 Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255
12.3.1 A Simple Model . . . . . . . . . . . . . . . . . . . . . . . 256
12.3.2 Interpreting Money Supply Fluctuations . . . . . . . . . . 258
12.4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260
12.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260
III Economic Growth and Development 261

13 Early Economic Development 263
13.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
13.2 Technological Developments . . . . . . . . . . . . . . . . . . . . . 264
13.2.1 Classical Antiquity (500 B.C. - 500 A.D.) . . . . . . . . . 264
13.2.2 The Middle Ages (500 A.D. - 1450 A.D.) . . . . . . . . . 265
13.2.3 The Renaissance and Baroque Periods (1450 A.D. - 1750
A.D.) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267
13.3 Thomas Malthus . . . . . . . . . . . . . . . . . . . . . . . . . . . 267
13.3.1 The Malthusian Growth Model . . . . . . . . . . . . . . . 269
13.3.2 Dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . 271
13.3.3 Technological Progress in the Malthus Model . . . . . . . 272
13.3.4 An Improvement in Health Conditions . . . . . . . . . . . 273
13.3.5 Confronting the Evidence . . . . . . . . . . . . . . . . . . 274
13.4 Fertility Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275
13.4.1 Policy Implications . . . . . . . . . . . . . . . . . . . . . 281
13.5 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282
13.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
viii CONTENTS
14 Modern Economic Development 285

14.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285
14.2 The Solow Model . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
14.2.1 Steady State in the Solow Model . . . . . . . . . . . . . . 292
14.2.2 Differences in Saving Rates . . . . . . . . . . . . . . . . . 293
14.2.3 Differences in Population Growth Rates . . . . . . . . . . 295
14.2.4 Differences in Technology . . . . . . . . . . . . . . . . . . 296
14.3 The Politics of Economic Development . . . . . . . . . . . . . . . 296
14.3.1 A Specific Factors Model . . . . . . . . . . . . . . . . . . 297
14.3.2 Historical Evidence . . . . . . . . . . . . . . . . . . . . . . 300
14.4 Endogenous Growth Theory . . . . . . . . . . . . . . . . . . . . . 302
14.4.1 A Simple Model . . . . . . . . . . . . . . . . . . . . . . . 303
14.4.2 Initial Conditions and Nonconvergence . . . . . . . . . . . 306
14.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308
Preface
The field of macroeconomic theory has evolved rapidly over the last quarter
century. A quick glance at the discipline’s leading journals reveals that virtu-
ally the entire academic profession has turned to interpreting macroeconomic
data with models that are based on microeconomic foundations. Unfortunately,
these models often require a relatively high degree of mathematical sophistica-
tion, leaving them largely inaccessible to the interested lay person (students,
newspaper columnists, business economists, and policy makers). For this rea-
son, most public commentary continues to be cast in terms of a language that
is based on simpler ‘old generation’ models learned by policymakers in under-
graduate classes attended long ago.
To this day, most introductory and intermediate textbooks on macroeco-
nomic theory continue to employ old generation models in expositing ideas.
Many of these textbooks are written by leading academics who would not be
caught dead using any of these models in their research. This discrepancy can
be explained, I think, by a widespread belief among academics that their ‘new
generation’ models are simply too complicated for the average undergraduate.
The use of these older models is further justified by the fact that they do in some
cases possess hidden microfoundations, but that revealing these microfounda-
tions is more likely to confuse rather than enlighten. Finally, it could be argued
that one virtue of teaching the older models is that it allows students to better
understand the language of contemporary policy discussion (undertaken by an
old generation of former students who were taught to converse in the language
of these older models).
While I can appreciate such arguments, I do not in general agree with them.
It is true that the models employed in leading research journals are complicated.
But much of the basic intuition embedded in these models can often be exposited
with simple diagrams (budget sets and indifference curves). The tools required
for such analysis do not extend beyond what is regularly taught in a good
undergraduate microeconomics course. And while it is true that many of the
older generation models possess hidden microfoundations, I think that it is
mistake to hide these foundations from students. Among other things, a good
understanding of a model’s microfoundations lays bare its otherwise hidden
assumptions, which is useful since it renders clearer the model’s limitations and
ix
x PREFACE
forces the student to think more carefully. A qualified professional can get away
with using ‘short cut’ models with hidden microfoundations, but in the hands of
a layman, such models can be the source of much mischief (bad policy advice).
I am somewhat more sympathetic to the last argument concerning language. A
potential pitfall of teaching macroeconomics using a modern language is that
students may be left in a position that leaves them unable to decipher the older
language still widely employed in policy debates. Here, I think it is up to the
instructor to draw out the mapping between old and new language whenever it
might be useful to do so. Unfortunately, translation is time-consuming. But it
is arguably a necessary cost to bear, at least, until the day the old technology
is no longer widely in use.
To understand why the new generation models constitute a better technol-
ogy, one needs to understand the basic difference between the two methodologi-
cal approaches. The old generation models rely primarily on assumed behavioral
relationships that are simple to analyze and seem to fit the historical data rea-
sonably well. No formal explanation is offered as to why people might rationally
choose follow these rules. The limitations of this approach are twofold. First,
the assumed behavioral relations (which can fit the historical data well) often
seemed to ‘break down’ when applied to the task of predicting the consequences
of new government policies. Second, the behavioral relations do not in them-
selves suggest any natural criterion by which to judge whether any given policy
makes people better or worse off. To circumvent this latter problem, various
ad hoc welfare criteria emerged throughout the literature; e.g., more unemploy-
ment is bad, more GDP is good, a current account deficit is bad, business cycles
are bad, and so on. While all of these statements sound intuitively plausible,
they constitute little more than bald assertions.
In contrast, the new generation of models rely more on the tools of microeco-
nomic theory (including game theory). This approach assumes that economic
decisions are made for a reason. People are assumed to have a well-defined
objective in life (represented by preferences). Various constraints (imposed by
nature, markets, the government, etc.) place restrictions on how this objec-
tive can be achieved. By assuming that people try to do the best they can
subject to these constraints, optimal behavioral rules can be derived instead of
assumed. Macroeconomic variables can then be computed by summing up the
actions of all individuals. This approach has at least two main benefits. First,
to the extent that the deep parameters describing preferences and constraints
are approximated reasonably well, the theory can provide reliable predictions
over any number of hypothetical policy experiments. Second, since preferences
are modeled explicitly, one can easily evaluate how different policies may af-
fect the welfare of individuals (although, the problem of constructing a social
welfare function remains as always). As it turns out, more unemployment is
not always bad, more GDP is not always good, a current account deficit is not
always bad, and business cycles are not necessarily bad either. While these
results may sound surprising to those who are used to thinking in terms of old
generation models, they emerge as logical outcomes with intuitive explanations
PREFACE xi
when viewed from the perspective of modern macroeconomic theory.

The goal of this textbook is to provide students with an introduction to the
microfoundations of macroeconomic theory. As such, it does not constitute a
survey of all the different models that inhabit the world of modern macroeco-
nomic research. It is intended primarily as an exposition designed to illustrate
the basic idea that underlies the modern research methodology. It also serves
to demonstrate how the methodology can be applied to interpreting macroeco-
nomic data, as well as how the approach is useful for evaluating the economic
and welfare consequences of different government policies. The text is aimed at
a level that should be accessible to any motivated third-year student. A good
understanding of the text should pay reasonable dividends, especially for those
who are inclined to pursue higher-level courses or possibly graduate school. But
even for those who are not so inclined, I hope that the text will at least serve
as interesting food for thought.
Of course, this is not the first attempt to bring the microeconomic founda-
tions of macroeconomic theory to an undergraduate textbook. An early attempt
is to be found in: Macroeconomics: A Neoclassical Introduction, by Merton
Miller and Charles Upton (Richard D. Irwin, Inc.,1974). This is still an excel-
lent text, although it is by now somewhat dated. More recent attempts include:
Macroeconomics, by Robert Barro (John Wiley and Sons, Inc., 1984); Macro-
economics: An Integrated Approach, by Alan Auerbach and Lawrence Kotlikoff
(MIT Press, 1998); and Macroeconomics, by Stephen Williamson (Addison Wes-
ley, 2002).
These are all excellent books written by some of the profession’s leading aca-
demics. But like any textbook, they each have their particular strengths and
weaknesses (just try writing one yourself). Without dwelling on the weaknesses
of my own text, let me instead highlight what I think are its strengths. First,
I present the underlying choice problems facing individuals explicitly and sys-
tematically throughout the text. This is important, I think, because it serves
to remind the student that to understand individual (and aggregate) behavior,
one needs to be clear about what motivates and constrains individual decision-
making. Second, I present simple mathematical characterizations of optimal
decision-making and equilibrium outcomes, some of which can be solved for an-
alytically with high-school algebra. Third, I try (in so far that it is possible)
to represent optimal choices and equilibrium outcomes in terms of indifference
curve and budget set diagrams. The latter feature is important because the po-
sition of an indifference curve can be used to assess the welfare impact of various
changes in the economic or physical environment. Fourth, through the use of
examples and exercises, I try to show how the theory can be used to interpret
data and evaluate policy.
The text also contains chapters that are not commonly found in most text-
books. Chapter 7, for example, the modern approach to labor market analysis,
which emphasizes the gross flows of workers across various labor market states
and interprets the phenomenon of unemployment as an equilibrium outcome.
xii PREFACE
Chapter 10 develops a simple, but explicit model of fiat money and Chapter
11 utilizes this tool to discuss nominal exchange rates (emphasizing the prob-
lem of indeterminacy). Finally, the section on economic development extends
beyond most texts in that it includes: a survey of technological developments
since classical antiquity; presents the Malthusian model of growth; introduces
the concept of endogenous fertility choice; and addresses the issue of special
interests in the theory of productivity differentials (along with the usual topics,
including the Solow model and endogenous growth theory).
I realize that it may not be possible to cover every chapter in a semester
long course. I view Chapters 1-6 as constituting ‘core’ material. Following the
exposition of this material, the instructor may wish to pick and choose among
the remaining chapters depending on available time and personal taste.
At this stage, I would like to thank all my past students who had to suffer
through preliminary versions of these notes. Their sharp comments (and in
some cases, biting criticisms) have contributed to a much improved text. I
would especially like to thank Sultan Orazbayez and Dana Delorme, both of
whom have spent hours documenting and correcting the typographical errors
in an earlier draft. Thoughtful comments were also received from Bob Delorme
and Janet Hua. I am also grateful for the thoughtful suggestions offered by
several anonymous reviewers. This text is still very much a work in progress
and I remain open to further comments and suggestions for improvement. If you
are so inclined, please send them to me via my email address: [email protected]
Part I
Macroeconomic Theory:
Basics
1
Chapter 1
The Gross Domestic

Product
1.1 Introduction
The GDP measures the value of an economy’s production of goods and services
(output, for short) over some interval of time. A related statistic, called the per
capita GDP, measures the value of production per person. Economists and pol-
icymakers care about the GDP (and the per capita GDP in particular) because
material living standards depend largely on what an economy produces in the
way of final goods and services. Residents of an economy that produces more
food, more clothes, more shelter, more machinery, etc., are likely to be better
off (at least, in a material sense) than citizens belonging to some other economy
producing fewer of these objects. As we shall see later on, the link between
an economy’s per capita GDP and individual well-being (welfare) is not always
exact. But it does seem sensible to suppose that by and large, higher levels
of production (per capita) in most circumstances translate into higher material
living standards.
Definition: The GDP measures the value of all final goods and services (out-
put) produced domestically over some given interval of time.
Let us examine this definition. First of all, note that the GDP measures only
the production of final goods and services; in particular, it does not include the
production of intermediate goods and services. Loosely speaking, intermediate
goods and services constitute materials that are used as inputs in the construc-
tion final goods or services. Since the market value of the final output already
reflects the value of its intermediate products, adding the value of intermediate
materials to the value of final output would overstate the true value of produc-
tion in an economy (one would, in effect, be double counting). For example,
3
4 CHAPTER 1. THE GROSS DOMESTIC PRODUCT
suppose that a loaf of bread (a final good) is produced with flour (an interme-
diate good). It would not make sense to add the value of flour separately in the
calculation of GDP since the flour has been ‘consumed’ in process of making
bread and since the market price of bread already reflects the value of the flour
that was used in its production.
Now, consider the term ‘gross’ in the definition of GDP. Economists make a
distinction between the gross domestic product and the net domestic product
(NDP). The NDP essentially corrects the GDP by subtracting off the value of
the capital that depreciates in the process of production. Capital depreciation
is sometimes also referred to as capital consumption.
Definition: The NDP is defined as the GDP less capital consumption.
A case could be made that the NDP better reflects an economy’s level of pro-
duction since it takes into account the value of capital that is consumed in the
production process. Suppose, for example, that you own a home that generates
$12,000 of rental income (output in the form of shelter services). Imagine fur-
ther that your tenants are university students who (over the course of several
parties) cause $10,000 in damage (capital consumption). While your gross in-
come is $12,000 (a part of the GDP), your income net of capital depreciation is
only $2,000 (a part of the NDP). If you are like most people, you probably care
more about the NDP than the GDP. In fact, environmental groups often advo-
cate the use of an NDP measure that defines capital consumption broadly to
include ‘environmental degradation.’ Conceptually, this argument makes sense,
although measuring the value of environmental degradation can be difficult in
practice.
Finally, consider the term ‘domestic’ in the definition of GDP. The term
‘domestic’ refers to the economy that consists of all production units (people
and capital) that reside within the national borders of a country. This is not
the only way to define an economy. One could alternatively define an economy
as consisting of all production units that belong to a country (whether or not
these production units reside in the country or not). For an economy defined in
this way, the value of production is called the Gross National Product (GNP).
Definition: The GNP measures the value of all final goods and services (out-
put) produced by citizens (and their capital) over some given interval of
time.
The discrepancy between GDP and GNP varies from country to country. In
Canada, for example, GDP has recently been larger than GNP by only two or
three percent. The fact that GDP exceeds GNP in Canada means that the value
of output produced by foreign production units residing in Canada is larger than
the value of output produced by Canadian production units residing outside of
Canada. While the discrepancy between GDP and GNP is relatively small for
Canada, the difference for some countries can be considerably larger.
1.2. HOW GDP IS CALCULATED 5
1.2 How GDP is Calculated
Statistical agencies typically estimate an economy’s GDP in two ways: the

income approach and the expenditure approach.1 In the absence of any mea-
surement errors, both approaches will deliver exactly the same result. Each
approach is simply constitutes a different way of looking at the same thing.
1.2.1 The Income Approach
As the name suggests, the income approach calculates the GDP by summing
up the income earned by domestic factors of production. Factors of production
can be divided into two broad categories: capital and labor. Let R denote the
income generated by capital and let L denote the income generated by labor.
Then the gross domestic income (GDI) is defined as:
GDI ≡ L + R.
Figure 1.1 plots the ratio of wage income as a ratio of GDP for the United
States and Canada over the period 1961-2002. From this figure, we see that
wage income constitutes approximately 60% of total income, with the remainder
being allocated to capital (broadly defined). Note that for these economies, these
ratios have remained relatively constant over time (although there appears to be
a slight secular trend in the Canadian data over this sample period). One should
keep in mind that the distribution of income across factors of production is not
the same thing as the distribution of income across individuals. The reason
for this is that in many (if not most) individuals own at least some capital
(either directly, through ownership of homes, land, stock, and corporate debt,
or indirectly through company pension plans).
1 There is also a third way, called the value-added or product approach, that I will not
discuss here.
FIGURE 1.1
GDP Income Components
United States and Canada
1961.1 - 2003.4
United States Canada

100 100
80 80
Wage Income Wage Income

Percent of GDP
60 60
40 40
Capital Income
Capital Income
20 20
0
65 70 75 80 85 90 95 00 65 70 75 80 85 90 95 00
1.2.2 The Expenditure Approach

In contrast to the income approach, the expenditure approach focuses on the
uses of GDP across various expenditure categories. Traditionally, these expen-
diture categories are constructed by dividing the economy into four sectors: (1)
a household sector; (2) a business sector; (3) a government sector; and (4) a
foreign sector. Categories (1) and (2) can be combined to form the private sec-
tor. The private sector and the government sector together form the domestic
sector.
Let C denote the expenditures of the household sector on consumer goods
and services (consumption), including imports. Let I denote the expenditures
of the business sector on new capital goods and services (investment), including
imports. Let G denote the expenditures by the government sector on goods
and services (government purchases), including imports. Finally, let X denote
the expenditures on domestic goods and services undertaken by residents of the
foreign sector (exports). Total expenditures are thus given by C + I + G + X. Of
course, some of the expenditures on C, I and G consist of spending on imports,
which are obviously not goods and services that are produced domestically. In
order to compute the gross domestic expenditure (GDE), on must subtract off
the value of imports, M. If one defines the term N X ≡ X − M (net exports),
then the GDE is given by:
GDE ≡ C + I + G + N X.
Figure 1.2 plots the expenditure components of GDP (as a ratio of GDP)
for the United States and Canada over the period 1961-2002. Once again, it is
1.2. HOW GDP IS CALCULATED 7
interesting to note the relative stability of these ratios over long periods of time.
To a first approximation, it appears that private consumption expenditures (on
services and nondurables) constitute between 50—60% of GDP, private invest-
ment expenditures constitute between 20—30% of GDP, government purchases
constitute between 20—25% of GDP, with N X averaging close to 0% over long
periods of time. Note, however, that in recent years, the United States has been
running a negative trade balance while Canada has been running a positive
trade balance.
FIGURE 1.2
GDP Expenditure Components
1961.1 - 2003.4

100 100
80 80
Percent of GDP
Consumption
60 60
Consumption
40 40
Investment
Investment
20 20
Government Government
Net Exports Net Exports
0 0
65 70 75 80 85 90 95 00 65 70 75 80 85 90 95 00
1.2.3 The Income-Expenditure Identity

So far, we have established that GDP ≡ GDI and GDP ≡ GDE. From these
two equivalence relations, it follows that GDE ≡ GDI. In other words, aggre-
gate expenditure is equivalent to aggregate income, each of which are equivalent
to the value of aggregate production. One way to understand why this must be
true is as follows. First, any output that is produced must also be purchased
(additions to inventory are treated purchases of new capital goods, or invest-
ment spending). Hence the value of production must (by definition) be equal
to the value of spending. Second, since spending by one individual constitutes
income for someone else, total spending must (by definition) be equal to total
income.
The identity GDI ≡ GDE is sometimes referred to as the income-expenditure
identity. Letting Y denote the GDI, most introductory macroeconomic text-
books express the income-expenditure identity in the following way:
Y ≡ C + I + G + X − M.
Note that since the income-expenditure identity is an identity, it always

holds true. However, it is very important to understand what this identity does
and does not imply. A natural inclination is to suppose that since the identity
is always true, one can use it to make theoretical or predictive statements. For
example, the identity seems to suggest that an expansionary fiscal policy (an
increase in G) must necessarily result in an increase in GDP (an increase in Y ).
In fact, the income-expenditure identity implies no such thing.
To understand why this is the case, what one must recognize is that an
identity is not a theory about the way the world works. In particular, the
income-expenditure identity is nothing more than a description of the world;
i.e., it is simply categorizes GDP into to its expenditure components and then
exploits the fact that total expenditure is by construction equivalent to total
income. To make predictions or offer interpretations of the data, one must
necessarily employ some type of theory. As we shall see later on, an increase in
G may or may not lead to an increase in Y , depending on circumstances. But
whether or not Y is predicted to rise or fall, the income-expenditure identity
will always hold true.
1.3 What GDP Does Not Measure

Before moving on, it is important to keep in mind what GDP does not measure
both in principle and in practice (i.e., things that should be counted as GDP in
principle, but may not be in practice).
In principle, GDP is supposed to measure the value of output that is in
some sense ‘marketable’ or ‘exchangeable’ (even if it is not actually marketed or
exchanged). For example, if you spend 40 hours a week working in the market
sector, your earnings measure the market value of the output you produce.
However, there are 168 hours in a week. What are you producing with your
remaining 126 hours? Some of this time may be spent producing marketable
output that is not exchanged in a market. Some examples here include the
time you spend doing housework, mowing the lawn, and repairing your car, etc.
Assuming that you do not like to do any of these things, you could contract
out these chores. If you did, what you pay for such services would be counted
as part of the GDP. But whether you contract out such services or not, they
clearly have value and this value should be counted as part of the GDP (even if
it is not always done so in practice).
The great majority of peoples’ time, however, appears to be employed in the
production of ‘nonmarketable’ output. Nonmarketable output may be either in
the form of consumption or investment. As a consumption good, a nonmar-
ketable output is an object that is simultaneously produced and consumed by
1.4. NOMINAL VERSUS REAL GDP 9
the individual producing it. An obvious example here is sleep (beyond what is
necessary to maintain one’s health). It is hard to get someone else to sleep for
you. A wide variety of leisure activities fall into this category as well (imagine
asking someone to go on vacation for you). As an investment good, a nonmar-
ketable output is an object that remains physically associated with the individ-
ual producing it. Time spent in school accumulating ‘human capital’ falls into
this category.2 A less obvious example may also include time spent searching
for work. Nonmarketable output is likely very large and obviously has value.
However, it is not counted as part of an economy’s GDP.
Another point to stress concerning GDP as a measure of ‘performance’ is
that it tells us nothing about the distribution of output in an economy. At best,
the (per capita) GDP can only give us some idea about the level of production
accruing to an ‘average’ individual in the economy.
Finally, it should be pointed out that there may be a branch of an economy’s
production flow should be counted as GDP in principle, but for a variety of
reasons, is not counted as such in practice. Ultimately, this problem stems with
the lack of information available to statistical agencies concerning the production
of marketable output that is either consumed by the producer or exchanged in
‘underground’ markets; see Appendix 1.A for details.
1.4 Nominal versus Real GDP

GDP was defined above as the value of output (income or expenditure). The
definition did not, however, specify in which units ‘value’ is to be measured. In
everyday life, the value of goods and services is usually stated in terms of market
prices measured in units of the national currency (e.g., Canadian dollars). For
example, the dozen bottles of beer you drank at last night’s student social cost
you $36 (and possibly a hangover). The 30 hours you worked last week cost
your employer $300; and so on. If we add up incomes and expenditures in this
manner, we arrive at a GDP figure measured in units of money; this measure is
called the nominal GDP.
If market prices (including nominal exchange rates) remained constant over
time, then the nominal GDP would make comparisons of GDP across time
and countries an easy task (subject to the caveats outlined in Appendix 1.A).
Unfortunately, as far as measurement issues are concerned, market prices do not
remain constant over time. So why is this a problem?
The value of either income or expenditure is measured as the product of
prices (measured in units of money) and quantities. It seems reasonable to
suppose that material living standards are somehow related to quantities; and
not the value of these quantities measured in money terms. In most economies
2 Note that while the services of the human capital accumulated in this way may subse-
quently be rented out, the human capital itself remains embedded in the individual’s brain.
As of this writing, no technology exists that allows us to trade bits of our brain.
(with some notable exceptions), the general level of prices tends to grow over
time; such a phenomenon is known as inflation. When inflation is a feature
of the economic environment, the nominal GDP will rise even if the quantities
of production remain unchanged over time. For example, consider an economy
that produces nothing but bread and that year after year, bread production is
equal to 100 loaves. Suppose that the price of bread ten years ago was equal
to $1.00 per loaf, so that the nominal GDP then was equal to $100. Suppose
further that the price of bread has risen by 10% per annum over the last ten
years. The nominal GDP after ten years is then given by (1.10)10 ($100) = $260.
Observe that while the nominal GDP is 2.6 times higher than it was ten years
ago, the ‘real’ GDP (the stuff that people presumably care about) has remained
constant over time.
Thus, while measuring value in units of money is convenient, it is also prob-
lematic as far as measuring material living standards. But if we can no longer
rely on market prices denominated in money to give us a common unit of mea-
surement, then how are we to measure the value of an economy’s output? If an
economy simply produced one type of good (as in our example above), then the
answer is simple: Measure value in units of the good produced (e.g., 100 loaves
of bread). In reality, however, economies typically produce a wide assortment
of goods and services. It would make little sense to simply add up the level of
individual quantities produced; for example, 100 loaves of bread, plus 3 tractors,
and 12 haircuts does not add up to anything that we can make sense of.
So we return to the question of how to measure ‘value.’ As it turns out, there
is no unique way to measure value. How one chooses to measure things depends
on the type of ‘ruler’ one applies to the measurement. For example, consider
the distance between New York and Paris. How does one measure distance? In
the United States, long distances are measured in ‘miles.’ The distance between
New York and Paris is 3635 miles. In France, long distances are measured in
‘kilometers’. The distance between Paris and New York is 5851 kilometers.
Thankfully, there is a fixed ‘exchange rate’ between kilometers and miles (1
mile is approximately 1.6 kilometers), so that both measures provide the same
information. Just as importantly, there is a fixed exchange rate between miles
across time (one mile ten years ago is the same as one mile today).
The phenomenon of inflation (or deflation) distorts the length of our measur-
ing instrument (money) over time. Returning to our distance analogy, imagine
that the government decides to increase the distance in a mile by 10% per year.
While the distance between New York and Paris is currently 3635 miles, after
ten years this distance will have grown to (1.10)10 (3635) = 9451 miles. Clearly,
the increase in distance here is just an illusion (the ‘real’ distance has remained
constant over time). Similarly, when there is an inflation, growth in the nom-
inal GDP will give the illusion of rising living standards, even if ‘real’ living
standards remain constant over time.
There are a number of different ways in which to deal with the measurement
issues introduced by inflation. Here, I will simply describe one approach that is
1.4. NOMINAL VERSUS REAL GDP 11
commonly adopted by statistical agencies. Consider an economy that produces

n different goods and services. Let t denote the time-period (e.g., year) under
consideration. Let xit denote the quantity of good i produced at date t and
let pit denote the money price of good i produced at date t. Statistical agencies
collect information on the expenditures made on each domestically produced
good and service; i.e., pit xit , for i = 1, 2, ..., n and for each year t. The gross
domestic expenditure (measured in current dollars) is simply given by:
n
X
GDEt = pit xit .
i=1
Now, choose one year arbitrarily (e.g., t = 1997) and call this the base
year. Then, the real GDP (RGDP) in any year t is calculated according to the
following formula:
Xn
RGDPt ≡ pi1997 xit .
i=1
This measure is called the GDP (expenditure based) in terms of base year (1997)
prices. In other words, the value of the GDP at date t is now measured in units
of 1997 dollars (instead of current, or date t dollars). Note that by construction,
RGDP1997 = GDE1997 .
As a by-product of this calculation, one can calculate the average level of
prices (technically, the GDP Deflator or simply, the price level ) Pt according to
the formula:
GDEt
Pt ≡ .
RGDPt
Note that the GDP deflator is simply an index number; i.e., it has no economic
meaning (in particular, note that P1997 = 1 by construction). Nevertheless, the
GDP deflator is useful for making comparisons in the price level across time.
That is, even if P1997 = 1 and P1998 = 1.10 individually have no meaning, we
can still compare these two numbers to make the statement that the price level
rose by 10% between the years 1997 and 1998.
The methodology just described above is not fool-proof. In particular, the
procedure of using base year prices to compute a measure of real GDP assumes
that the structure of relative prices remains constant over time. To the extent
that this is not true (it most certainly is not), then measures of the growth
rate in real GDP can depend on the arbitrary choice of the base year.3 Finally,
it should be noted that making cross-country comparisons is complicated by
the fact that nominal exchange rates tend to fluctuate over time as well. In
principle, one can correct for variation in the exchange rate, but how well this
is accomplished in practice remains an open question.
3 Some statistical agencies have introduced various ‘chain-weighting’ procedures to mitigate
this problem.
1.5 Real GDP Across Time

Figure 1.3 plots the time path of real (i.e., corrected for inflation) per capita
GDP for the United States and Canada since the first quarter of 1961.
FIGURE 1.3
Real per capita GDP
1961.1 - 2003.4

48000 36000
44000 32000
1997 CDN$ Per Annum

2000 US$ Per Annum
40000 28000
36000 24000
32000 20000
28000 16000
24000 12000
20000 8000
65 70 75 80 85 90 95 00 65 70 75 80 85 90 95 00
The pattern of economic development for these two countries in Figure 1.3 is
typical of the pattern of development observed in many industrialized countries
over the last century and earlier. The most striking feature in Figure 1.3 is that
real per capita income tends to grow over time. Over the last 100 years, the rate
of growth in these two North American economies has averaged approximately
2% per annum.
Now, 2% per annum may not sound like a large number, but one should
keep in mind that even very low rates of growth can translate into very large
changes in the level of income over long periods of time. To see this, consider
the ‘rule of 72,’ which tells us the number of years n it would take to double
incomes if an economy grows at rate of g% per annum:
72
n= .
g
Thus, an economy growing at 2% per annum would lead to a doubling of income
every 36 years. In other words, we are roughly twice as rich as our predecessors
who lived here in 1967; and we are four times as rich as those who lived here in
1931.
Since our current high living standards depend in large part on past growth,
and since our future living standards (and those of our children) will depend
on current and future growth rates, understanding the phenomenon of growth
is of primary importance. The branch of macroeconomics concerned with the
1.5. REAL GDP ACROSS TIME 13
issue of long-run growth is called growth theory. A closely related branch of

macroeconomics, which is concerned primarily with explaining the level and
growth of incomes across countries, is called development theory. We will discuss
theories of growth and development in the chapters ahead.
Traditionally, macroeconomics has been concerned more with the issue of
‘short run’ growth, or what is usually referred to as the business cycle. The
business cycle refers to the cyclical fluctuations in GDP around its ‘trend,’
where trend may defined either in terms of levels or growth rates. From Figure
1.3, we see that while per capita GDP tends to rise over long periods of time,
the rate of growth over short periods of time can fluctuate substantially. In fact,
there appear to be (relatively brief) periods of time when the real GDP actually
falls (i.e., the growth rate is negative). When the real GDP falls for two or
more consecutive quarters (six months), the economy is said to be in recession.
Figure 1.4 plots the growth rate in real per capita GDP for the United States
and Canada.
FIGURE 1.4
Growth Rate in Real Per Capita GDP
(5-quarter moving average)
8
4
Percent per Annum
-2
-4
-6
U.S. Canada
-8
65 70 75 80 85 90 95 00
Figure 1.4 reveals that the cyclical pattern of GDP growth in the United
States and Canada are similar, but not identical. In particular, note that
Canada largely escaped the three significant recessions that afflicted the U.S.
during the 1970s (although growth did slow down in Canada during these
episodes). Both Canada and the U.S. experienced a relatively deep recession
during the early 1980s, with the recession being somewhat deeper in Canada.
Both economies also experienced a recession in the early 1990s, with the reces-
sion in Canada being both deeper and more prolonged. Finally, observe that
the most recent recession in the U.S. was relatively mild by historical standards.
In Canada, growth fell to relatively low rates, but largely remained positive.
1.6 Schools of Thought

The reason for why aggregate economic activity fluctuates the way it does, even
in relatively stable institutional environments, remains largely an unresolved
puzzle. Most macroeconomists interpret the business cycle as the product of
economic behavior in response to various ‘shocks’ that are thought to afflict
economies at a high frequency. Unfortunately, these high-frequency shocks (if
they exist at all) are difficult to measure directly, leading to much debate con-
cerning the ultimate source of the business cycle. Furthermore, economists are
often divided on how they view an economy reacting to any given shock. Thus
there are many different schools of thought that are distinguished by which
shocks they choose to emphasize and/or in their explanation of how the econ-
omy reacts to any given shock.
There are two broad strands of thinking (each with its own many variations)
in terms of understanding the business cycle. The first strand, which I will refer
to as the ‘conventional wisdom,’ owes its intellectual debt primarily to the work
of John Maynard Keynes (1936), whose views on the business cycle were likely
shaped to a large extent by the experience of the Great Depression. Almost
every principles course in macroeconomics is taught according to the Keynesian
perspective, which goes a long way to explaining why this view has become the
conventional one among market analysts, central bankers, and policymakers in
general. In academic circles, certain elements of this view live on in the work of
the New-Keynesian school of thought.
According to conventional wisdom, the long-run trend rate of growth in real
per capita GDP is considered to be more or less constant (e.g., 2% per annum).
The level of GDP consistent with this trend is sometimes referred to as potential
GDP. Fluctuations in GDP around trend are thought to be induced by various
‘aggregate demand’ shocks, for example, an unexplained sudden surge in desired
spending on the part of the consumer, the business sector, the government
sector, or the foreign sector. At a deeper level, the private sector spending shocks
are commonly thought to be the result of ‘irrational’ swings in consumer and
business sector ‘sentiment,’ or what Keynes (1936) referred to as ‘animal spirits.’
Any given shock influences market outcomes (like the GDP and employment)
adversely, primarily because private markets are viewed as being subject to
a host of various ‘imperfections.’ These imperfections are usually thought to
take the form of ‘sticky’ prices and/or credit market imperfections arising from
1.6. SCHOOLS OF THOUGHT 15
imperfect information in financial markets.

The conventional view asserts that in an ideal world, the economy’s actual
GDP would always be equal to its potential GDP. In other words, the business
cycle is largely viewed as evidence of a malfunctioning market system. Given
this interpretation of the cycle, it should come as no surprise that this view also
advocates the use of various government stabilization policies (active monetary
and fiscal policy) to mitigate the adverse consequences of the cycle.
The second strand of thinking is the neoclassical perspective. This school
of thought is closer in spirit to the views of Joseph Schumpeter (1939). In
academic circles, the neoclassical perspective is embodied in the work of a school
of thought called Real Business Cycle Theory.
According to the neoclassical view, the distinction between ‘growth’ and ‘cy-
cles’ is largely an artificial one. Almost everyone agrees that long-run growth
is the product of technological advancement. But unlike the New-Keynesian
school, which views trend growth as being relatively stable, the neoclassical
view is that there is no God-given reason to believe that the process of tech-
nological advancement proceeds in such a ‘smooth’ manner. Indeed, it seems
more reasonable to suppose that new technologies appear in ‘clusters’ over time.
These ‘technology shocks’ may cause fluctuations in the trend rate of growth
through what Schumpeter called a process of ‘creative destruction.’ That is,
technological advancements that ultimately lead to higher productivity may, in
the short run, induce cyclical adjustments as the economy ‘restructures’ (i.e.,
as resources flow from declining sectors to expanding sectors).
As with the conventional wisdom, the neoclassical view admits that sudden
changes in private sector expectations may lead to sudden changes in desired
consumer and business sector spending. But unlike the conventional wisdom,
these changes are interpreted as reflecting the ‘rational’ behavior of private sec-
tor decision-makers in response to perceived real changes in underlying economic
fundamentals (i.e., technology shocks). In other words, changes in market sen-
timent are the result and not the cause of the business cycle.
According to the neoclassical view, the business cycle is an unfortunate but
largely unavoidable product of the process of economic development. Given this
interpretation of the cycle, it should come as no surprise to learn that the policy
implication here is that government attempts to stabilize the cycle are likely to
do more harm than good.
In the chapters to come, we will explore the relative merits and shortcomings
of each of these perspectives. For the student, I recommend keeping an open
mind with respect to each perspective, since there is likely an element of truth
in each of these diverse views.
1.7 Problems
1. While Americans constitute a relatively small fraction of the world’s pop-
ulation (less than 5%), they spend approximately 20% of the world’s in-
come. This fact is sometimes used as evidence of American ‘greed.’ Pro-
vide a different interpretation of this fact based on your knowledge of the
relationship between aggregate expenditure and output.
2. One often reads how much of the world’s population subsists on ‘less than
$1 a day.’ Explain why such reports grossly underestimate the level of per
capita income actually produced in the world’s underdeveloped economies
(see Appendix 1.A).
3. The residential capital stock produces a flow of output in the form of

‘shelter services.’ When a landlord rents out his or her residence, the
value of this output is measured by the rental income generated by the
asset. However, many residences are ‘owner-occupied’ so that no direct
measure of rental income is available (for example, if you own your own
home, you do not typically write out a rental cheque to yourself each
month). Nevertheless, statisticians attempt to impute a number to the
value of output generated by owner-occupied housing. Explain how this
might be done.
4. Your father keeps a vegetable garden in the backyard, the output of which
is consumed by household members. Should the value of this output be
counted toward an economy’s GDP? If so, how might a statistician mea-
sure the value of such output from a practical standpoint? Explain any
similarity and differences between this example and the previous example
of owner-occupied housing.
5. Explain why ‘overpaid’ government employees will lead to an overstate-

ment of GDP, whereas ‘overpaid’ private sector employees will not (see
Appendix 1.A).
6. Consider an economy that produces bananas and bread. You have the
following measurements:
Bananas Bread
Quantity (2003) 100 50
Price (2003) $0.50 $1.00
Quantity (2004) 110 60
Price (2004) $0.50 $1.50
(a) Compute the GDP in each year using current prices. Compute the
growth rate in nominal GDP.
(b) Compute the real GDP in each year first using 2003 as the base year
and then using 2004 as the base year. How does the rate of growth in
1.8. REFERENCES 17
real GDP depend on which base year is used? Explain. (Hint: note
that the price of bread relative to bananas has increased).
7. Consider two economies A and B that each have a real per capita GDP
equal to $1,000 in the year 1900. Suppose that economy A grows at 2%
per annum, while economy B grows at 1.5% per annum. The difference
in growth rates does not seem very large, but compute the GDP in these
two economies for the year 2000. In percentage terms, how much higher
is the real GDP in economy A compared to economy B?
1.8 References
1. Keynes, John M. (1936). The General Theory of Employment, Interest
and Money, MacMillan, Cambridge University Press.
2. Schumpeter, Joseph A. (1939). Business Cycles: A Theoretical, Historical
and Statistical Analysis of the Capitalist Process, New York, McGraw-Hill.
1.A Measured GDP: Some Caveats
Have you ever wondered how GDP figures are calculated in practice? Probably
not...but let me tell you anyway.
In principle, the GDP is calculated either by summing up incomes or ex-
penditures over some specified period of time (e.g., month, quarter, year). This
sounds simple in principle—but how is it done in practice? Does the govern-
ment or some other organization keep a running tab on everybody’s income and
expenditures at all times? No, this is not how it works.
In practice, data is collected from a variety of sources using a variety of
methods. For example, government statistical agencies may have access to pay-
roll data or personal and business income tax forms and use this information to
construct an estimate of income. As well, these same statistical agencies may
perform regular surveys of randomly selected establishments (within a variety
of sectors) to gather sales data from which to form an estimate of expenditure.
Thus, it is important to keep in mind that available GDP numbers are just
estimates (which are often revised over time), whose quality depends in part
on the resources that are spent in collecting information, the information that
is available, and on the methodology used in constructing estimates. It is not
clear that any of these factors remain constant over time or are similar across
countries.
Another thing to keep in mind is that measuring the value of income and ex-
penditure in the way just described largely limits us to measurements of income
and expenditure (and hence, the production of output) that occur in ‘formal’
markets. For present purposes, one can think of a formal market as a place
where: [1] output exchanges for money at an observable price; and [2] the value
of what is exchanged is observable by some third party (i.e., the government or
some statistical agency).
It is likely that most of the marketable output produced in the so-called
developed world is exchanged in formal markets, thanks largely to an extensive
market system and revenue-hungry governments eager to tax everything they
can (in the process keeping records of the value of what is taxed). In many
economies, however, a significant fraction of marketable output is likely ex-
changed in markets with observable money prices, but where the value of what
is exchanged is ‘hidden’ (and hence, not measurable). The reason for hiding
the value of such exchanges is often motivated by a desire to evade taxes or
because the exchange itself is legally prohibited (e.g., think of the marijuana
industry in British Columbia or the cocaine industry in Colombia). The out-
put produced in the so-called ‘underground economy’ should, in principle, be
counted as part of an economy’s GDP, but is not owing to the obvious problem
of getting individuals to reveal their underground activities.
A large fraction of the marketable output produced in the so-called under-
developed world is likely exchanged in informal markets. The reason for this is
1.A. MEASURED GDP: SOME CAVEATS 19
twofold. First, one thing that characterizes underdeveloped economies is lack

of formal market structures, particularly in rural areas (where output is largely
consumed by the household, or perhaps bartered in small and informal trans-
actions). The lack of local market prices thus requires statistical agencies to
impute market value, which are calculations that require resources that may
not be available. Second, many rural regions in the underdeveloped world oper-
ate largely in the absence of any (federal) government intervention (taxation).
Since tax information constitutes an important source of data for estimating
income, the lack of any federal-level record-keeping system outside of urban ar-
eas may severely hinder the collection of any relevant data. These measurement
problems should especially be kept in mind when attempting to make cross-
country comparisons of GDP (especially across developed and less-developed
economies).
Finally, a word needs to be said about an asymmetry that exists in the
measurement of private versus public sector activity. Consider the following
example. The private sector consists of a household sector and a business sector.
The household sector generates labor income and the business sector generates
capital income. Members of the household sector are employed in either the
business sector or the government sector. Let WP denote wage income from
those employed in the business sector and WG denote wage income from those
employed in the government sector. The household sector also pays taxes T, so
that total after-tax household earnings are given by:
WP + WG − T.
The business sector produces and sells output (at market prices), which
generates revenue YP . Capital income is therefore given by:
YP − WP .
Adding up the two equations above yields us the after-tax income of the private
sector:
YP + WG − T.
The government sector produces output YG . Measuring the value of YG ,

however, is problematic since most of what a government produces is not sold
at market prices (it is largely given away). Nevertheless, one could impute a
value for YG . Having done so, government sector income is given by:
YG + T − WG .
If we add up private-sector and government-sector income (the previous two

equations), we arrive at a figure for total income; i.e., Y = YP + YG .
The key question here is how to impute a value for YG ? The way this is done
in practice is to assume:
YG = WG .
In other words, it is assumed that the value of what is produced by government

employees is equal to what the government pays for their services.
To see the potential problem of this method of imputation, consider an
extreme case in which government employees produce nothing of value so that
in truth YG = 0 and Y = YP . In this case, the government wage bill WG in fact
represents a transfer of income from one part of the population to another; i.e.,
it does not represent the (market) value of newly produced goods and services.
In this case, imputing the value YG = WG overstates the value of government-
produced output and will therefore overstate an economy’s GDP.
Chapter 2
Basic Neoclassical Theory
2.1 Introduction
In this chapter, we develop a simple theory (based on the neoclassical perspec-

tive) that is designed to explain the determination of output and employment
(hours worked). The object is to construct a model economy, populated by in-
dividuals that make certain types of decisions to achieve some specified goal.
The decisions that people make are subject to a number of constraints so that
inevitably, achieving any given goal involves a number of trade-offs. In many
respects, the theory developed here is too simple and suffers from a number of
shortcomings. Nevertheless, it will be useful to study the model, since it serves
as a good starting point and can be extended in a number of dimensions as the
need arises.
For the time being, we will focus on the output of consumer goods and
services (hence, ignoring the production of new capital goods or investment);
i.e., so that I ≡ 0. For simplicity, we will focus on an economy in which labor is
the only factor of production (Appendix 2.A extends the model to allow for the
existence of a productive capital stock). For the moment, we will also abstract
from the government sector, so that G ≡ 0. Finally, we consider the case of
a closed economy (no international trade in goods or financial assets), so that
N X ≡ 0. From our knowledge of the income and expenditure identities, it
follows that in this simple world, C ≡ Y ≡ L. In other words, all output is in
the form of consumer goods purchased by the private sector and all (claims to)
output are paid out to labor.
A basic outline of the neoclassical model is as follows. First, it is assumed
that individuals in the economy have preferences defined over consumer goods
and services so that there is a demand for consumption. Second, individuals also
have preferences defined over a number of nonmarket goods and services, that
are produced in the home sector (e.g., leisure). Third, individuals are endowed
21
22 CHAPTER 2. BASIC NEOCLASSICAL THEORY
with a fixed amount of time that they can allocate either to the labor market
or the home sector. Time spent in the labor market is useful for the purpose of
earning wage income, which can be spent on consumption. On the other hand,
time spent in the labor market necessarily means that less time can be spent in
other valued activities (e.g., home production or leisure). Hence individuals face
a trade-off: more hours spent working imply a higher material living standard,
but less in the way of home production (which is not counted as GDP). A key
variable that in part determines the relative returns to these two activities is
the real wage rate (the purchasing power of a unit of labor).
The production of consumer goods and services is organized by firms in
the business sector. These firms have access to a production technology that
transforms labor services into final output. Firms are interested in maximizing
the return to their operations (profit). Firms also face a trade-off: Hiring more
labor allows them to produce more output, but increases their costs (the wage
bill). The key variables that determine the demand for labor are: (a) the
productivity of labor; and (b) the real wage rate (labor cost).
The real wage is determined by the interaction of individuals in the household
sector and firms in the business sector. In a competitive economy, the real
wage will be determined by (among other things) the productivity of labor.
The productivity of labor is determined largely by the existing structure of
technology. Hence, fluctuations in productivity (brought about by technology
shocks) may induce fluctuations in the supply and demand for labor, leading to
a business cycle.
2.2 The Basic Model

The so-called basic model developed here contains two simplifying assumptions.
First, the model is ‘static’ in nature. The word ‘static’ should not be taken to
mean that the model is free of any concept of time. What it means is that the
decisions that are modeled here have no intertemporal dimension. In particular,
choices that concern decisions over how much to save or invest are abstracted
from. This abstraction is made primarily for simplicity and pedagogy; in later
chapters, the model will be extended to ‘dynamic’ settings. The restriction to
static decision-making allows us, for the time-being, to focus on intratemporal
decisions (such as the division of time across competing uses). As such, one can
interpret the economy as a sequence t = 1, 2, 3, ..., ∞ of static outcomes.
The second abstraction involves the assumption of ‘representative agencies.’
Literally, what this means is that all households, firms and governments are
assumed to be identical. This assumption captures the idea that individual
agencies share many key characteristics (e.g., the assumption that more is pre-
ferred to less) and it is these key characteristics that we choose to emphasize.
Again, this assumption is made partly for pedagogical reasons and partly be-
cause the issues that concern us here are unlikely to depend critically on the fact
2.2. THE BASIC MODEL 23
that individuals and firms obviously differ along many dimensions. We are not,
for example, currently interested in the issue of income distribution. It should
be kept in mind, however, that the neoclassical model can be (and has been)
extended to accommodate heterogeneous decision-makers.
2.2.1 The Household Sector

Imagine an economy with (identical) households that each contain a large num-
ber (technically, a continuum) of individuals. The welfare of each household is
assumed to depend on two things: (1) a basket of consumer goods and services
(consumption); and (2) a basket of home-produced goods and services (leisure).
Let c denote consumption and let l denote leisure. Note that the value of home-
produced output (leisure) is not counted as a part of the GDP.
How do households value different combinations of consumption and leisure?
We assume that households are able to rank different combinations of (c, l) ac-
cording to a utility function u(c, l). The utility function is just a mathemati-
cal way of representing household preferences. For example, consider two ‘al-
locations’ (cA , lA ) and (cB , lB ). If u(cA , lA ) > u(cB , lB ), then the household
prefers allocation A to allocation B; and vice-versa if u(cA , lA ) < u(cB , lB ). If
u(cA , lA ) = u(cB , lB ), then the household is indifferent between the two allo-
cations. We will assume that it is the goal of each household to act in a way
that allows them to achieve the highest possible utility. In other words, house-
holds are assumed to do the best they can according to their preferences (this
is sometimes referred to as maximizing behavior).
It makes sense to suppose that households generally prefer more of c and
to less, so that u(c, l) is increasing in both c and l. It might also make sense to
suppose that the function u(c, l) displays diminishing marginal utility in both
c and l. In other words, one extra unit of either c or l means a lot less to me
if I am currently enjoying high levels of c and l. Conversely, one extra unit of
either c or l would mean a lot more to me if I am currently enjoying low levels
of c and l.
Now, let us fix a utility number at some arbitrary value; i.e., u0 . Then,
consider the expression:
u0 = u(c, l). (2.1)
This expression tells us all the different combinations of c and l that generate the
utility rank u0 . In other words, the household is by definition indifferent between
all the combinations of c and l that satisfy equation (2.1). Not surprisingly,
economists call such combinations an indifference curve.
Definition: An indifference curve plots all the set of allocations that yield the
same utility rank.
If the utility function is increasing in both c and l, and if preferences are such
that there is diminishing marginal utility in both c and , then indifference curves
have the properties that are displayed in Figure 2.1, where two indifference
curves are displayed with u1 > u0 .
FIGURE 2.1
Indifference Curves
c
Direction of
Increasing Utility
u1
u0
0 l
Households are assumed to have transitive preferences. That is, if a house-

hold prefers (c1 , l1 ) to (c2 , l2 ) and also prefers (c2 , l2 ) to (c3 , l3 ), then it is also
true that the household prefers (c1 , l1 ) to (c3 , l3 ). The transitivity of preferences
implies the following important fact:
Fact: If preferences are transitive, then indifference curves can never cross.
Keep in mind that this fact applies to a given utility function. If preferences
were to change, then the indifference curves associated with the original prefer-
ences may cross those indifference curves associated with the new preferences.
Likewise, the indifference curves associated with two different households may
also cross, without violating the assumption of transitivity. Ask your instructor
to elaborate on this point if you are confused.
An important concept associated with preferences is the marginal rate of
substitution, or M RS for short. The definition is as follows:
Definition: The marginal rate of substitution (MRS) between any two goods
is defined as the (absolute value of the) slope of an indifference curve at
any allocation.
The M RS has an important economic interpretation. In particular, it mea-

sures the household’s relative valuation of any two goods in question (in this
case, consumption and leisure). For example, consider some allocation (c0 , l0 ),
which is given a utility rank u0 = u(c0 , l0 ). How can we use this information
to measure a household’s relative valuation of consumption and leisure? Imag-
ine taking away a small bit ∆l of leisure from this household. Then clearly,
u(c0 , l0 − ∆l ) < u0 . Now, we can ask the question: How much extra consump-
tion ∆c would we have to compensate this household such that they are not
made any worse off? The answer to this question is given by the ∆c that satis-
fies the following condition:
u0 = u(c0 + ∆c , l0 − ∆l ).
For a very small ∆l , the number ∆c /∆l gives us the slope of the indifference
curve in the neighborhood of the allocation (c0 , l0 ). It also tells us how much
this household values consumption relative to leisure; i.e., if ∆c /∆l is large, then
leisure is valued highly (one would have to give a lot of extra consumption to
compensate for a small drop in leisure). The converse holds true if ∆c /∆l is a
small number.
Before proceeding, it may be useful to ask why we (as theorists) should be
interested in modeling household preferences in the first place. There are at
least two important reasons for doing so. First, one of our goals is to try to pre-
dict household behavior. In order to predict how households might react to any
given change in the economic environment, one presumably needs to have some
idea as to what is motivating their behavior in the first place. By specifying
the objective (i.e., the utility function) of the household explicitly, we can use
this information to help us predict household behavior. Note that this remains
true even if we do not know the exact form of the utility function u(c, l). All
we really need to know (at least, for making qualitative predictions) are the
general properties of the utility function (e.g., more is preferred to less, etc.).
Second, to the extent that policymakers are concerned with implementing poli-
cies that improve the welfare of individuals, understanding how different policies
affect household utility (a natural measure of economic welfare) is presumably
important.
Now that we have modeled the household objective, u(c, l), we must now
turn to the question of what constrains household decision-making. Households
are endowed with a fixed amount of time, which we can measure in units of either
hours or individuals (assuming that each individual has one unit of time). Since
the total amount of available time is fixed, we are free to normalize this number
to unity. Likewise, since the size of the household is also fixed, let us normalize
this number to unity as well.
Households have two competing uses for their time: work (n) and leisure (l),
so that:
n + l = 1. (2.2)
Since the total amount of time and household size have been normalized to unity,
we can interpret n as either the fraction of time that the household devotes to
work or the fraction of household members that are sent to work at any given
date.
Now, let w denote the consumer goods that can be purchased with one unit
of labor. The variable w is referred to as the real wage. For now, let us simply
assume that w > 0 is some arbitrary number beyond the control of any individ-
ual household (i.e., the household views the market wage as exogenous). Then
consumer spending for an individual household is restricted by the following
equation:1
c = wn.
By combining the time constraint (2.2) with the budget constraint above, we
see that household choices of (c, l) are in fact constrained by the equation:
c = w − wl. (2.3)
This constraint makes it clear that an increase in l necessarily entails a reduction

in material living standards c.
Before proceeding, a remark is in order. Note that the ‘money’ that workers
get paid is in the form of a privately-issued claim against the output to be
produced in the business sector. As such, this ‘money’ resembles a coupon
issued by the firm that is redeemable for merchandise produced by the firm.2
We are now ready to state the choice problem facing the household. The
household desires an allocation (c, l) that maximizes utility u(c, l). However,
the choice of this allocation (c, l) must respect the budget constraint (2.3). In
mathematical terms, the choice problem can be stated as:
Choose (c, l) to maximize u(c, l) subject to: c = w − wl.
Let us denote the optimal choice (i.e., the solution to the choice problem above)
as (cD , lD ), where cD (w) can be thought of as consumer demand and lD (w)
can be thought of as the demand for leisure (home production). In terms of a
diagram, the optimal choice is displayed in Figure 2.2 as allocation A.
1 This equation anticipates that, in equilibrium, non-labor income will be equal to zero. This
result follows from the fact that we have assumed competitive firms operating a technology
that utilizes a single input (labor). When there is more than one factor of production, the
budget constraint must be modified accordingly; i.e., see Appendix 2.A.
2 For example, in Canada, the firm Canadian Tire issues its own money redeemable in
merchandise. Likewise, many other firms issue coupons (e.g., gas coupons) redeemable in
output. The basic neoclassical model assumes that all money takes this form; i.e., there is no
role for a government-issued payment instrument. The subject of money is taken up in later
chapters.
FIGURE 2.2
Household Choice
Budget Line
w c = w - wl
D A
c
-w
0 lD 1.0
S
n
Figure 2.2 contains several pieces of information. First note that the budget
line (the combinations of c and l that exhaust the available budget) is linear,
with a slope equal to −w and a y-intercept equal to w. The y-intercept indi-
cates the maximum amount of consumption that is budget feasible, given the
prevailing real wage w. In principle, allocations such as point B are also budget
feasible, but they are not optimal. That is, allocation A is preferred to B and is
affordable. An allocation like C is preferred to A, but note that allocation C is
not affordable. The best that the household can do, given the prevailing wage
w, is to choose an allocation like A.
As it turns out, we can describe the optimal allocation mathematically. In
particular, one can prove that only allocation A satisfies the following two con-
ditions at the same time:
M RS(cD , lD ) = w; (2.4)
D D
c = w − wl .
The first condition states that, at the optimal allocation, the slope of the in-
difference curve must equal the slope of the budget line. The second condition
states that the optimal allocation must lie on the budget line. Only the alloca-
tion at point A satisfies these two conditions simultaneously.
• Exercise 2.1. Using a diagram similar to Figure 2.2, identify an alloca-

tion that satisfies M RS = w, but is not on the budget line. Can such an
allocation be optimal? Now identify an allocation that is on the budget
line, but where M RS 6= w. Can such an allocation be optimal? Explain.
Finally, observe that this theory of household choice implies a theory of labor
supply. In particular, once we know lD , then we can use the time constraint to
infer that the desired household labor supply is given by nS = 1 − lD . Thus, the
solution to the household’s choice problem consists of a set of functions: cD (w),
lD (w), and nS (w).
Substitution and Wealth Effects Following a Wage Change
Figure 2.3 depicts how a household’s desired behavior may change with an
increase in the return to labor. Let allocation A in Figure 2.3 depict desired
behavior for a low real wage, wL . Now, imagine that the real wage rises to
wH > wL . Figure 2.3 shows that the household may respond in three general
ways, which are represented by the allocations B,C, and D.
An increase in the real wage has two effects on the household budget. First,
the price of leisure (relative to consumption) increases. Second, household
wealth (measured in units of output) increases. These two effects can be seen
in the budget constraint (2.3), which one can rewrite as:
c + wl = w.
The right hand side of this equation represents household wealth, measured in
units of consumption (i.e., the y-intercept in Figure 2.3). Thus a change in
wt induces what is called a wealth effect (WE). The left hand side represents
the household’s expenditure on consumption and leisure. The price of leisure
(measured in units of foregone consumption) is w; i.e., this is the slope of the
budget line. Since a change in w also changes the relative price of consumption
and leisure, it will induce what is called a substitution effect (SE).
From Figure 2.3, we see that an increase in the real wage is predicted to in-
crease consumer demand. This happens because: (1) the household is wealthier
(and so can afford more consumption); and (2) the price of consumption falls
(relative to leisure), inducing the household to substitute away from leisure and
into consumption. Thus, both wealth and substitution effects work to increase
consumer demand.
Figure 2.3 also suggests that the demand for leisure (the supply of labor)
may either increase or decrease following an increase in the real wage. That
is, since wealth has increased, the household can now afford to purchase more
leisure (so that labor supply falls). On the other hand, since leisure is more
expensive (the return to work is higher), the household may wish to purchase
less leisure (so that labor supply rises). If this substitution effect dominates
the wealth effect, then the household will choose an allocation like B in Figure
2.3. If the wealth effect dominates the substitution effect, then the household
will choose an allocation like C. If these two effects exactly cancel, then the
household will choose an allocation like D (i.e., the supply of labor does not
change in response to an increase in the real wage). But which ever case occurs,
we can conclude that the household is made better off (i.e., they will achieve a
higher indifference curve).
FIGURE 2.3
Household Response to an
Increase in the Real Wage
c
wH
(SE > WE)

B
wL (SE = WE)
D
C (SE < WE)
0 1.0 l
• Exercise 2.2. Consider the utility function u(c, l) = ln c + λ ln l, where

λ ≥ 0 is a preference parameter that measures how strongly a household
feels about consuming home production (leisure). For these preferences,
we have M RS = λc/l. Using the conditions in (2.4), solve for the house-
hold’s labor supply function. How does labor supply depend on the real
wage here? Explain. Suppose now that preferences are such that the MRS
is given by M RS = (c/l)1/2 . How does labor supply depend on the real
wage? Explain.
• Exercise 2.3. Consider two household’s that have preferences as in the

exercise above, but where preferences are distinguished by different values
for λ; i.e., λH > λL . Using a diagram similar to Figure 2.2, depict the
different choices made by each household. Explain. (Hint: the indifference
curves will cross).
2.2.2 The Business Sector

Our model economy is populated by a number of (identical) business agencies
that operate a production technology that transforms labor services (n) into
output (in the form of consumer goods and services) (y). We assume that this
production technology takes a very simple form:
y = zn;
where z > 0 is a parameter that indexes the efficiency of the production process.
We assume that z is determined by forces that are beyond the control of any
individual or firm (i.e., z is exogenous to the model).
In order to hire workers, each firm must pay its workers the market wage w.
Again, remember that the assumption here is that firms can create the ‘money’
they need by issuing coupons redeemable in output. Let d denote the profit
(measured in units of output) generated by a firm; i.e.,
d = (z − w)n. (2.5)
Thus, the choice problem for a firm boils down to choosing an appropriate labor
force n; i.e.,
Choose (n) to maximize (z − w)n subject to 0 ≤ n ≤ 1.
The solution to this choice problem, denoted nD (the labor demand func-
tion), is very simple and depends only on (z, w). In particular, we have:
⎧
⎨ 0 if z < w;
nD = n if z = w;
⎩
1 if z > w;
where n in the expression above is any number in between 0 and 1. In words,

if the return to labor (z) is less than the cost of labor (w), then the firm will
demand no workers. On the other hand, if the return to labor exceeds the cost
of labor, then the firm will want to hire all the labor it can. If the return to
labor equals the cost of labor, then the firm is indifferent with respect to its
choice of employment (the demand for labor is said to be indeterminate in this
case). With the demand for labor determined in this way, the supply of output
is simply given by y S = znD .
Notice that the demand for labor depends on both w and z, so that we can
write nD (w, z). Labor demand is (weakly) decreasing in w. That is, suppose
that z > w so that labor demand is very high. Now imagine increasing w
higher and higher. Eventually, labor demand will fall to zero. The demand for
labor is also (weakly) increasing in z. To see this, suppose that initially z < w.
Now imagine increasing z higher and higher. Eventually, labor demand will be
equal 1. Thus, anything that leads to an improvement in the efficiency of the
production technology will generally serve to increase the demand for labor.
2.2.3 General Equilibrium

So far, we have said nothing about how the real wage (the relative price of
output and leisure) is determined. In describing the choice problem of house-
holds and firms, we assumed that the real wage was beyond the control of any
individual household or firm. This assumption can be justified by the fact that,
in a competitive economy, individuals are small relative to the entire economy,
so that individual decisions are unlikely to influence market prices. But market
prices do not generally fall out of thin air. It makes sense to think of prices as
ultimately being determined by aggregate supply and aggregate demand con-
ditions in the market place. So, it is now time to bring households and firms
together and describe how they interact in the market place. The outcome of
this interaction is called a general equilibrium.
The economy’s general equilibrium is defined as an allocation (c∗ , y ∗ , n∗ , l∗ )
and a price system (w∗ ) such that the following is true:
1. Given w∗ , the allocation (c∗ , n∗ , l∗ ) maximizes utility subject to the budget

constraint [households are doing the best they can];
2. Given (w∗ , z), the allocation (y ∗ , n∗ ) maximizes profit [firms are doing the
best they can];
3. The price system (w∗ ) clears the market [ nS (w∗ ) = nD (w∗ , z) or cD (w∗ ) =
y S (w∗ , z) ].
In words, the general equilibrium concept is asking us to interpret the world

as a situation in which all of its actors are trying to do the best they can (sub-
ject to their constraints) in competitive markets. Observed prices (equilibrium
prices) are likewise interpreted to be those prices that are consistent with the
optimizing actions of all individuals taken together.
Before we examine the characteristics of the general equilibrium, it is useful
to summarize the pattern of exchanges that are imagined to occur in each period;
i.e., see Figure 2.4. One can imagine that each period is divided into two stages.
In the first stage, workers supply their labor (n) to firms in exchange for coupons
(M ) redeemable for y units of output. The real GDI at this stage is given by
y. In the second stage (after production has occurred), households take their
coupons (M ) and redeem them for output (y). Since M represents a claim
against y, the real GDE at this stage is given by y. And since firms actually
produce y, the real GDP is given by y as well.
FIGURE 2.4
Pattern of Exchange
Stage 2:
Redemption M
Phase
y
Households Firms
l n
M
Stage 1:
Labor-Output Market
Now let us proceed to describe the general equilibrium in more detail. From
the definition of equilibrium, real wage will satisfy the labor market clearing
condition:
nS (w∗ ) = nD (w∗ , z).
If household preferences are such that zero levels of consumption or leisure

are extremely undesirable, then the equilibrium will look something like that
depicted in Figure 2.5.
FIGURE 2.5
Equilibrium in the Labor Market
n
1.0
nS
n*
nD
0 w* = z w
Notice that the upward sloping labor supply function reflects an underlying
assumption about the relative strength of the substitution and wealth effects
associated with changes in the real wage; i.e., here we are assuming that SE
> WE. The peculiar shape of the labor demand function follows from our as-
sumption that the production function is linear in employment. If instead we
assumed a diminishing marginal product of labor (the standard assumption),
the labor demand function would be decreasing smoothly in the real wage. Such
an extension is considered in Appendix 2.A.
In general, the equilibrium real wage is determined by both labor supply
and demand (as in Appendix 2.A). However, in our simplified model (featuring
a linear production function), we can deduce the equilibrium real wage solely
from labor demand. In particular, recall that the firm’s profit function is given
by d = (z − w)n. For n∗ to be strictly between 0 and 1, it must be the case that
w∗ = z (so that d∗ = 0). That is, the real wage must adjust to drive profits
to zero so that the demand for labor is indeterminate. With w∗ determined in
this way, the equilibrium level of employment is then determined entirely by
the labor supply function; i.e., n∗ = nS (w∗ ). The general equilibrium allocation
and equilibrium real wage is depicted in Figure 2.6.
FIGURE 2.6
General Equilibrium
c* = y*
-z
0 l* 1.0
n*
Observe that in this simple model, the equilibrium budget constraint just
happens to lie on top of the PPF. For this reason, it may be easy to confuse the
two, but you should always remember that the budget constraint and the PPF
are not equivalent concepts.3
Thus, our theory makes a prediction over various real quantities (c∗ , y ∗ , n∗ , l∗ )
and the real wage w∗ . These ‘starred’ variables are referred to as the model’s
endogenous variables; i.e., these are the objects that the theory is designed to
explain. Notice that the theory here (as with any theory) contains variables
that have no explanation (as far as the theory is concerned). These variables
are treated as ‘God-given’ and are labelled exogenous variables. In the theory
developed above, the key exogenous variables are z (technology) and u (pref-
erences). Thus, the theory is designed to explain how its endogenous variables
3 For example, see the more general model developed in Appendix 2.1.
2.3. REAL BUSINESS CYCLES 35
react to any particular (unexplained) change in the set of exogenous variables.
• Exercise 2.4. Consider the general equilibrium allocation depicted in

Figure 2.6. Is the real GDP maximized at this allocation? If not, which
allocation does maximize GDP? Would such an allocation also maximize
economic welfare? If not, which allocation does maximize economic wel-
fare? What are the policy implications of what you have learned here?
2.3 Real Business Cycles
Many economists in the past have pointed out that the process of technological
development itself may be largely responsible for the business cycle.4 The basic
idea is that we have no reason to believe a priori that productivity should
grow in perfectly smooth manner. Perhaps productivity growth has a relatively
smooth trend, but there are likely to be transitory fluctuations in productivity
around trend as the economy grows.
To capture this idea in our model, let us suppose that the productivity
parameter z fluctuates around some given ‘trend’ level. Figure 2.7 depicts how
the equilibrium allocation will fluctuate (assuming that SE > WE on labor
supply) across three different productivity levels: zH > zM > zL .
4 Classic examples include: Schumpeter (1942), Kydland and Prescott (1982), and Long
and Plosser (1983).

FIGURE 2.7
Business Cycles: Productivity Shocks
y*H
y*L
0 1.0
n*L
n*H
• Exercise 2.5. Using a diagram similar to Figure 2.5, demonstrate what
effect productivity shocks have on the equilibrium in the labor market.
From Figures 2.5 and 2.7, we see that a positive productivity shock (e.g.,
an increase in z from zM to zH ) has the effect of increasing the demand for
labor (since labor is now more productive). The increase in labor demand puts
upward pressure on the real wage, leading households to substitute time away
from home production and into the labor market. Real GDP rises for two
reasons: (1) employment is higher; and (2) labor is more productive. Economic
welfare also increases. The same results, but in reverse, apply when the economy
is hit by a negative productivity shock.
The main prediction of the neoclassical model is that cyclical fluctuations in
productivity should naturally result in a business cycle. In other words, one can-
not simply conclude (say from Figure 1.4) that the business cycle is necessarily
2.3. REAL BUSINESS CYCLES 37
the result of a malfunctioning market system. According to this interpretation,

the business cycle reflects the market’s optimal reaction to exogenous changes
in productivity.
One way to ‘test’ the real business cycle interpretation is to see whether the
model’s predictions for other economic aggregates are broadly consistent with
observation. In particular, note that the model developed above (as with more
elaborate versions of the model) predicts that employment (or hours worked),
labor productivity, and the real wage should all basically move in the same
direction as output over the cycle (i.e., these variables should display procyclical
behavior). Figure 2.8 displays the cyclical relationships between these variables
in the U.S. economy.
FIGURE 2.8
The U.S. Business Cycle:
Growth Rates in Selected Aggregates
(5 quarter moving averages)
8 8
6 6
4 4
Percent per Annum
Percent per Annum
2 2
0 0
-2 -2
-4 -4
-6 -6
65 70 75 80 85 90 95 00 65 70 75 80 85 90 95 00
Real per capita GDP Hours per capita Real per capita GDP Labor Productivity
8 6
6 4
4
Percent per Annum
Percent per Annum
2
2
0
0
-2
-2
-4 -4
-6 -6
65 70 75 80 85 90 95 00 65 70 75 80 85 90 95 00
Real per capita GDP Real Wage Hours per capita Real Wage
From Figure 2.8, we see that hours worked do tend to move in the same di-
rection as output over the cycle, which is consistent with our model. However,
the correlation between output and hours is not perfect.5 Both labor produc-
tivity and the real wage are also procyclical, but much less than what our model
predicts. But the real problem with our theory appears to be with the behavior
of hours worked vis-à-vis the real wage. In this data, at least, there appears
little relation between wage movements and hours over the cycle.
2.3.1 The Wage Composition Bias

While the behavior of hours and wages may be taken as a rejection of our
simple model, it does not necessarily constitute a rejection of the real business
cycle hypothesis. In particular, it is possible to construct more elaborate (i.e.,
realistic) versions of the neoclassical model that are consistent with the data.
One such extension involves modeling the fact that workers differ in skill
(in our version of the model, we assumed that all workers were identical). As
it turns out, most of the cyclical fluctuations in hours takes the form of lower-
skilled workers moving into and out of employment. Furthermore, the market
return to factory work, construction, and other lower skilled trades appears to be
much more volatile than, say, the market return enjoyed by doctors and lawyers.
To the extent that this is true, then the average real wage (computed as the
total wage bill divided by hours worked) is likely to suffer from a composition
bias.6
The composition bias refers to the fact that the composition of skills in
the workforce changes over the business cycle. During a cyclical downturn, for
example, since lower-skilled workers are more prone to losing their jobs, the
average quality of the workforce increases (so that the measured real wage will
be higher than if the average quality of the workforce remained unchanged).
To see how this might work, consider the following example. Suppose that the
economy consists of workers: a fraction (1 − θ) are high-skilled and a fraction θ
are low-skilled. High-skilled workers earn a stable wage (since their productivity
is relatively stable) equal to wH . Suppose, however, that the productivity of
low-skilled workers fluctuates so that their real wages fluctuate over the cycle;
i.e., wL (zH ) > wL (zL ). All workers can either work full-time or not (i.e., time
is indivisible). The return to home production v is the same for all workers.
Assume that:
wH > wL (zH ) > v > wL (zL ).
In this simple model, when productivity is high (zH ), all individuals will
choose to work and when productivity is low (zL ), only high-skilled individuals
5 In particular, note that during the most recent recovery, output has grown while hours
worked have continued to decline. This pattern is also evident (but to a lesser extent) during
the recovery of the early 1990s. In the popular press, this type of behavior has come to be
called a ‘jobless recovery,’ and is the subject of much current policy debate. We will return
to this issue shortly.
6 See: Solon, Barsky and Parker (1994).
2.4. POLICY IMPLICATIONS 39
will work. Thus, the composition of skills in the workforce changes with z, since
lower-skilled individuals do not work when productivity is low. Consequently,
the ‘average’ wage among employed workers in this model will be countercyclical
(i.e., move in the opposite direction of output). That is, when productivity is
low, the average real wage is given by wH . But when productivity is high, the
average real wage is given by (1 − θ)wH + θwL (zH ) < wH . Thus, the fact that
the measured ‘average’ real wage is not strongly procyclical may be more of a
measurement problem than a problem with the theory.7
2.4 Policy Implications

To the extent that real economies are subjected to exogenous productivity
shocks, our model predicts that the economy will display business cycle behav-
ior. The resulting cycles of economic activity induce changes in the economic
welfare of individuals as measured by the level of utility (notice how the indif-
ference curves in Figure 2.7 move up and down with the cycle).
The business cycle is often viewed as a ‘bad’ thing. This is certainly true
in our model; in particular, our model people would be happier (enjoy higher
lifetime utility) in the absence of fluctuations around trend levels. The business
cycle is also often viewed as evidence of a ‘malfunctioning’ market economy; a
view that invariably calls for some sort of government intervention to ‘fix’ the
problem. This interpretation and policy advice, however, is not consistent with
our model.
In our model, the equilibrium allocation is in fact efficient (in the sense
of being Pareto optimal ). In other words, markets work to allocate resources
over the cycle in precisely the ‘correct’ way. Individuals may not like the fact
that productivity fluctuates around trend, but given that it does, they respond
optimally to the changes in their environment brought about by productivity
shocks. The implications for policy are rather stark: the government should do
nothing. While it may be in the power for the government to stabilize economic
aggregates, any attempt to do so would only make the ‘average’ person worse
off.
To demonstrate this point formally, let us consider the following example.
Consider an economy that is initially at the equilibrium point A in Figure 2.11.
Now, suppose that productivity falls for some exogenous reason. In the absence
of any government intervention, the economy moves into recession (point B in
Figure 2.11), as both output and employment decline. Now, suppose that the
government has the power to stabilize employment (for example, by subsidizing
wage costs for firms). The government does not, however, have the power to
prevent the decline in productivity. In this case, the equilibrium allocation
would be given by an allocation like C in Figure 2.11. Note that this government
7 For example, when one corrects for the composition bias, Liu (2003) finds that the return
to work is strongly procyclical.

intervention has the effect of stabilizing employment and reducing the decline
in GDP. While this may, on the surface, sound like a good thing, note that this
government stabilization policy reduces economic welfare.
FIGURE 2.11
Government Stabilization Policy
A
y*H
y0
C B
y*L
0 n*L 1.0
n0
To understand the intuition behind this policy advice, consider the follow-
ing example. Imagine that our country is hit by an unusually harsh winter
(or perhaps a breakdown in the power grid, as happened recently in eastern
North America). Among other things, extremely cold weather reduces the pro-
ductivity of labor in many sectors of the economy. Many firms (like those in
the construction sector) reduce their demand for labor, or what amounts to
the same thing, reduce the amount they would be willing to pay for less pro-
ductive labor. Individuals respond to the temporary decline in productivity by
reallocating time away from the market sector into the home sector (so that
employment and output falls). In principle, the government could step in to
‘stabilize’ the decline in employment. One way they could do this is by offering
wage subsidies (financed by some type of tax). Another more direct way would
be to pass legislation forcing individuals to work harder. But what would be the
2.5. UNCERTAINTY AND RATIONAL EXPECTATIONS 41
point of such an intervention? The fundamental ‘problem’ here is the decline in

productivity; and there is nothing that the government can do to prevent winter
from coming.
2.5 Uncertainty and Rational Expectations

In the neoclassical model, expectations are viewed as passively adjusting them-
selves to changing economic fundamentals. To understand what this means, let
us modify the model above to incorporate an element of uncertainty over the
level of productivity z. Imagine that z can take on one of two values: zH > zL .
Let π(z, s) denote the probability of z occurring, conditional on receiving some
information s (a signal that is correlated with productivity).
The way the economy works is as follows. At the beginning of each period,
individuals receive a signal s that is either ‘good’ or ‘bad;’ i.e., s ∈ {g, b}. If
people observe the good signal, then it is known that zH is more likely than zL .
On the other hand, if people observe the ‘bad’ signal, then it is known that zL
is more likely than zH . In other words,
π(zH , g) > π(zL , g); (2.6)

π(zH , b) < π(zL , b).
After observing the signal, assume that workers and firms must commit to
a level of employment (before actually knowing the true level of productivity
that occurs). This assumption captures the idea that some investments must
be undertaken without knowing for sure what the actual return will be.
A key assumption made in the neoclassical model is that individuals un-
derstand the ‘fundamentals’ governing the random productivity parameter; i.e.,
they ‘know’ the function π, as well as the variables (z, s). These fundamentals
are viewed as being determined by God or nature. In other words, for better or
worse, this is just the way things are; i.e., the world is an uncertain place and
people must somehow cope with this fact of life.
So how might individuals cope with such uncertainty? It seems reasonable
to suppose that they form expectations over z, given whatever information they
have available. Since individuals (in our model) are aware of the underlying
fundamentals of the economy, they can form ‘rational’ expectations. Let z e (s)
denote the expected value for z conditional on having the information s. Then
it is easy to calculate:
z e (g) = π(zH , g)zH + π(zL , g)zL ; (2.7)

z e (b) = π(zH , b)zH + π(zL , b)zL .
Given the probability structure described in (2.6), it is clear that z e (g) > z e (b).
In other words, if people observe the ‘good’ signal, they are ‘optimistic’ that
productivity is likely to be high. Conversely, if people receive the ‘bad’ signal,

they are ‘pessimistic’ and believe that productivity is likely to be low. As
information varies over time (i.e., as good and bad signals are observed), it will
appear as if the ‘mood’ or ‘confidence’ of individuals varies over time as well.
These apparent mood swings, however, have nothing to with psychology; i.e.,
they reflect entirely rational changes in expectations that vary as the result of
changing fundamentals (information).
In our model, firms always earn (in equilibrium) zero profits—both in an
expected and actual (before and after uncertainty is resolved). What this implies
is that the expected wage must be given by we (s) = z e (s) and the actual wage
must be given by w∗ (z) = z. By assumption, however, employment decisions
must be based on the expected wage. Since actual employment in our model is
determined entirely by labor supply, household decision-making determines the
level of employment and the (expected) level of consumer demand; i.e.,8
M RS(ce (s), 1 − n∗ (s)) = we (s);

ce (s) = we (s)n∗ (s).
In this model, observing a good signal will result in an employment boom

(since the expected return to labor is high). Conversely, observing a bad signal
will result in an employment bust (since the expected return to labor is low).
The economics here are exactly the same as what has been described earlier.
The only difference here is that actual GDP (consumption) will in general differ
from expected GDP (consumption). That is, actual GDP is given by y ∗ (z, s) =
zn∗ (s) = c∗ (z, s).
Thus, it appears that individuals will in general make ‘mistakes’ in the sense
of regretting past (employment) decisions. Note, however, there is nothing
‘irrational’ about making such mistakes. At the time decisions were to be made,
actions were made on the basis of the best possible information available. If this
is true, then our conclusion about the role of government stabilization policies
continues to hold.
• Exercise 2.6. Use a diagram to depict a situation where s = g but where

productivity ends up being low (i.e., z = zL ).
2.6 Animal Spirits

The neoclassical view that expectations passively adjust to changing economic
fundamentals is not one that is shared by all economists and policymakers. In
some circles, there is a strong view that expectations appear to be driven by
psychological factors and not by changes in economic fundamentals. According
8 Instructors: For this mathematical characterization to hold exactly, we must assume that
certainty equivalence holds (e.g., assume that preferences are quadratic).

2.6. ANIMAL SPIRITS 43
to this view, exogenous (i.e., unexplained) changes in expectations themselves

constitute an important source of ‘shocks’ for an economy. These ‘expectation
shocks’ are called animal spirits—a colorful phrase coined by Keynes (1936, pp.
161—162):
“Even apart from the instability due to speculation, there is the in-
stability due to the characteristic of human nature that a large pro-
portion of our positive activities depend on spontaneous optimism
rather than mathematical expectations, whether moral or hedonis-
tic or economic. Most, probably, of our decisions to do something
positive, the full consequences of which will be drawn out over many
days to come, can only be taken as the result of animal spirits -
a spontaneous urge to action rather than inaction, and not as the
outcome of a weighted average of quantitative benefits multiplied by
quantitative probabilities.”
As with much of Keynes’ writing, the ideas expressed here are simultane-
ously thought-provoking and ambiguous. This ambiguity is evident in the way
scholars have interpreted the notion of animal spirits. One interpretation is
that animal spirits constitute ‘irrational’ (psychological) fluctuations in ‘mood’
that are largely independent of economic fundamentals.9 Another interpretation
is that animal spirits are driven by psychological factors, but are nevertheless
consistent with individual (not necessarily social) rationality to the extent that
exogenous shifts in expectations become self-fulfilling prophesies (i.e., the eco-
nomic fundamentals themselves can depend on expectations).10 In what follows,
I try to formalize each of these views.
2.6.1 Irrational Expectations

Let us reconsider the model developed in Section 2.5. One way to model ‘ir-
rational’ expectations is as follows. Assume, for simplicity, that the true level
of productivity remains fixed over time at some level z. In this world then,
economic fundamentals remain constant. However, suppose that for some un-
explained reason (e.g., ‘psychological’ factors), individuals form expectations
according to (2.7). These expectations are not consistent with the underlying
reality of the economy; i.e., they are irrational given the fact that z remains
constant over time. Nevertheless, individuals (for some unexplained reason) act
on signals that bear no relationship to economic fundamentals (these signals are
useless for forecasting productivity).
9 This interpretation is popular in policy circles. Consider, for example, when Federal
Reserve Chairman Alan Greenspan warned us of ‘irrational exuberance’ in the stock market.
1 0 Keynes (1936, pg. 246) himself can be interpreted as adopting this view when he remarks
that an economy “seems capable of remaining in a chronic condition of sub-normal activity

for a considerable period without any marked tendency either towards recovery or towards
complete collapse.”
If the world did operate in the way just described, then there would be a
business cycle even in the absence of any changes in economic fundamentals.
When s = g, individuals become ‘optimistic’ (in fact, they become overly opti-
mistic). This optimism leads to a boom in employment and output. Likewise,
when s = b, individuals become ‘pessimistic’ (in fact, they become overly pes-
simistic). This pessimism leads to a bust in employment and output. These
fluctuations in output and employment occur despite the fact that z remains
constant.
• Exercise 2.7. Use a diagram to depict the economy’s general equilibrium

when expectations are rational (i.e., the neoclassical view). Now depict a
situation in which individuals irrationally act on a signal s = g (revising
upward their forecast of productivity). Are individuals made better off by
the resulting boom in output and employment? Explain.
Needless to say, if one was inclined to adopt this view of the world, the
policy implications are potentially quite different from the neoclassical view.
In this world, the business cycle is clearly a ‘bad’ thing, since it is entirely
the product of overly optimistic and overly pessimistic fluctuations in private
sector expectations. If the government could design an effective stabilization
policy, then such a policy is likely to improve economic welfare. Keep in mind,
however, that to design such a policy one must assume that the government in
some way has better information concerning the ‘true’ state of the economy than
the private sector. Whether this might be true or not is an empirical question
(and one that is not fully resolved).
2.6.2 Self-Fulfilling Prophesies

A self-fulfilling prophesy is a situation where an exogenous change in expecta-
tions can alter economic reality in a way that is consistent with the change in
expectations. Some of us may have had experiences that fit this description.
For example, you wake up on the morning before an exam and (for some unex-
plained reason) expect to fail the exam regardless of how hard you study. With
this expectation in place, it makes no sense to waste time studying (you may
as well go to the bar and at least enjoy the company of friends). Of course, the
next day you write the exam and fail, confirming your initial expectation (and
rationalizing your choice of visiting the bar instead of studying). But suppose
instead that you woke up that fateful morning and (for some unexplained rea-
son) expect to pass the exam with a last-minute cram session. The next day you
write the exam and pass, confirming your initial expectation (and rationalizing
your decision to study rather than drinking).
According to this story, what actually ends up happening (pass or fail) de-
pends critically on what sort of ‘mood’ you wake up with in the morning before
the exam. Your mood is uncontrollable. But given your mood, you can form
2.6. ANIMAL SPIRITS 45
expectations rationally and act accordingly. Your actions and outcomes can be
consist with your initial expectations.
This example is probably not the best one since it relates one’s expectation
only to oneself. But the same idea can apply to how one’s expectations are
formed in relation to the behavior of others. Suppose, for example, that the
existing technology is such that the return to your own labor is high when
everyone else is working hard. Conversely, the return to your labor is low when
everyone else is slacking off. Imagine that you must make a decision of how hard
to work based on an expectation of how hard everyone else is going to work. If I
expect everyone else to work hard, it makes sense for me to do so as well. On the
other hand, if I expect everyone else to slack off, then it makes sense for me to
do so as well. This is an example of what is called a strategic complementarity
(Cooper, 1999). A strategic complementarity occurs when the payoff to any
action I take depends positively on similar actions taken by everyone else.
If the economy is indeed characterized by strategic complementarities, then
the possibility of coordination failure exists. To illustrate the idea of coor-
dination failure, imagine that everyone wakes up one morning and (for some
unexplained reason) expect everyone else to work hard. Then the equilibrium
outcome becomes a self-fulfilling prophesy, since at the individual level it makes
sense for everyone to work hard under these expectations. Of course, the con-
verse holds true if everyone (for some unexplained reason) wakes up in the
morning expecting everyone else to slack off. In this latter scenario, expecta-
tions are coordinated on a ‘bad’ equilibrium outcome (which is what people
mean by coordination failure).
This basic idea can be modeled formally as follows. Imagine that the econ-
omy’s production technology takes the following form:
½
zH n if n ≥ nC ;
y=
zL n if n < nC ;
where nC denotes some ‘critical’ level of aggregate employment and n represents
the actual level of aggregate employment. This technology exhibits a form of
increasing returns to scale. In particular, if aggregate employment is low (in
the sense of being below nC ), then productivity is low as well. Conversely, if
aggregate employment is high (in the sense of being at least as large as nC ), then
productivity is high as well. Hence, the level of productivity depends critically
on whether employment is high or low in this economy.
As before, the equilibrium real wage in this economy will equal the marginal
product of labor (z). Imagine that households wake up in the morning expecting
some z. Then their optimal consumption-labor choices must satisfy:
M RS(c∗ (z), 1 − n∗ (z)) = z;
c∗ (z) = zn∗ (z).
In equilibrium, the aggregate (average) level of employment must correspond to
each household’s individual employment choice. Assume that n∗ (zL ) < nC <
n∗ (zH ). These two possible outcomes are displayed in Figure 2.12 as points A
and B.
FIGURE 2.12
Multiple Equilibria
zH
A
y*H
zL
B
y*L
0 1.0
n*L
nC
n*H
Notice that both points A and B are consistent with a rational expectations
general equilibrium. In the neoclassical model studied earlier, the general equi-
librium was unique (owing to the constant returns to scale in the production
technology). In the model studied here, however, there are multiple equilib-
ria. Each equilibrium is generated by a self-fulfilling prophesy. Individuals are
clearly better off in equilibrium A. However, if individuals coordinate their ex-
pectations on B, then this outcome too is a possibility. Whether outcome A or
B occurs depends on an arbitrary set of initial expectations. Exogenous changes
in these initial expectations may cause the economy to fluctuate between points
A and B over time. On the other hand, if beliefs become ‘stuck’ at point B, the
2.7. SUMMARY 47
economy may experience a prolonged self-fulfilling ‘depression.’11
• Exercise 2.8. Consider Figure 2.12. Suppose you expect a low level of
aggregate employment and output. Suppose, however, that you decided to
‘work hard;’ i.e., choose n = nH . Draw an indifference curve that shows the
level of consumption (and utility) you can expect to enjoy and explain why
it is not rational to make such a choice. Suppose instead that you expect
a high level of aggregate employment and output. Further, suppose that
you decide to ‘slack off;’ i.e., choose n = nL . Again, draw an indifference
that shows the level of consumption (and utility) you can expect to enjoy
and explain why it is not rational for you to make such a choice.
As with the earlier interpretation of animal spirits, this view of the world
suggests a potential role for government policy. Suppose, for example, the econ-
omy appears to be stuck at a ‘bad’ equilibrium (point B). In this situation, the
‘demand’ for output appears to be weak and the level of employment is low.
Such a scenario may rationalize a large fiscal expenditure on the part of the
government. The government might do this by placing orders for output in the
market, or by hiring individuals directly to work in government agencies that
produce output. Either way, the demand for labor can be increased beyond the
threshold nC . By doing so, individual expectations must rationally move from
point B to point C.
2.7 Summary
The neoclassical view of the business cycle is that fluctuations are induced by the
actions of rational agents in response to exogenous changes brought about the
natural process of technological development. Economic expansions are periods
where the expected return to market activity is high. Recessions are periods
where the expected return to market activity is low. Expectations may fluctuate
even in the absence of any immediate changes in underlying productivity (as
people may receive information leading them to revise their estimates on the
future returns to current investments). While expectations play a critical role
in the neoclassical view, private sector expectations only shift in response to
perceived changes in the underlying economic fundamentals in an economy.
Often, expectations are wrong; i.e., things may turn out better or worse than
expected. Nevertheless, expectations are viewed as being ‘rational’ in the sense
of being formed in a way that is consistent with the underlying probability
structure governing the realizations of random events. In this view of the world,
government stabilization policies are likely to do more harm than good.
An alternative view of the cycle suggests that expectations may have a ‘life
of their own’ in the sense that they may shift for ‘psychological’ reasons that
1 1 From the quote from Keynes in footnote 9, this scenario appears to describe his interpre-
tation of the Great Depression.

may not be related in any way to changing economic fundamentals. One version
of this view asserts that expectations are ‘irrational’ in the sense of bearing no
relationship whatsoever to fundamentals. Another version of this view asserts
that exogenous changes in expectations may induce self-fulfilling prophesies. In
either of these cases, there is a clear potential role for government stabilization
policies. Note that this conclusion can hold even if markets are assumed to
‘clear’ in the neoclassical sense (as is the case with all the models developed in
this chapter). But whether the government can, as a practical matter, identify
an ‘irrational’ expectation or the existence of a self-fulfilling prophesy remains
open to question.
2.8. PROBLEMS 49
2.8 Problems
1. You are asked to write a brief newspaper column explaining the real busi-
ness cycle interpretation of the business cycle. Obviously, you cannot
use mathematical notation or make any use of diagrams. Furthermore,
your audience will generally not be familiar with economic jargon. Limit
yourself to 800 words or less.
2. Why is it important for any economic model to have the preferences of
individuals stated explicitly?
3. Does the fact that the expectations of private agents may differ from actual
outcomes necessarily imply a role for government policy? Explain.
4. Which of the two versions of the ‘animal spirits’ hypothesis described in
the text do you find more plausible? Explain why you feel this way (what
sort of evidence do you have to support your view)?
5. Imagine that a technological advance appears that favors some sectors
of the economy while hurting others. Should the government attempt to
stabilize the level of employment in declining sectors? How would such a
policy likely to affect growth in an economy? What other sort of policy
might the government undertake to facilitate the movement of factors from
declining industries to expanding sectors of the economy?
2.9 References
1. Cooper, Russell (1999). Coordination Games: Complementarities and
Macroeconomics, New York: Cambridge University Press.
2. Keynes, John M. (1936). The General Theory of Employment, Interest
and Money, MacMillan, Cambridge University Press.
3. Kydland, Finn and Edward C. Prescott (1982). “Time to Build and Ag-
gregate Fluctuations,” Econometrica, 50(6): 1145—1170.
4. Liu, Haoming (2003). “A Cross-Country Comparison of the Cyclicality of
Real Wages, Canadian Journal of Economics, 36(4): 923—948.
5. Long, John B. and Charles Plosser (1983). “Real Business Cycles,” Jour-
nal of Political Economy, 91(1): 39—69.
6. Schumpeter, Joseph A. (1942). Capitalism, Socialism, and Democracy,
Reprinted by Harper-Collins (1975).
7. Solon, Gary, Barsky, Robert and Jonathan A. Parker (1994). “Measuring
the Cyclicality of Real Wages: How Important is the Composition Bias?”
Quarterly Journal of Economics, 109(1): 1—25.
2.A A Model with Capital and Labor

The model of time allocation developed in this chapter assumed that labor is the
only factor of production. If there are constant returns to scale in production,
then this motivates the existence of a production function that takes the form
y = zn.
The model is easily extended to include two factors of production, which we
can think of as capital (k) and labor (n). In this case, the production function
can be written in a general form as y = zF (k, n). A specific functional form
for F is the Cobb-Douglas specification: F (k, n) = k1−θ nθ , where 0 ≤ θ ≤ 1 is
a parameter that indexes the relative importance of labor in production. Our
earlier model is just the special case in which θ = 1.
As this is a static model, assume that the amount of capital is fixed in supply;
for example, suppose that k = 1. The production function can then be written
as y = znθ . What this tells us is that output is an increasing function of labor
(as before). However, as employment expands, output does not expand in a
linear manner (as it did before). In particular, output expands at a declining
rate. The reason for this is because as more labor works with a given amount
of capital, the average (and marginal) product of labor declines.
For this production function, the marginal product of labor is given by:
M P L(n, z) = θznθ−1 .
The marginal product of labor tells us the extra output that can be produced
with one additional unit of labor. On a diagram, the MPL can be depicted
as the slope of the production function. Observe that when θ = 1, we have
M P L(n, z) = z (i.e., the MPL is a constant). When θ < 1, then the MPL
declines (the slope of the production function becomes flatter) as n increases.
As well, note that for a given level of n, an increase in z implies an increase in
the MPL.
The choice problem facing a typical firm is given by:
Choose (n) in order to maximize d = znθ − wn.
The solution to this choice problem is a desired labor input (labor demand)
function nD , which happens to satisfy the following condition:
M P L(nD , z) = w.
As an exercise, you should try to solve for the labor demand function nD and
show that it is decreasing in w and increasing in z. Once we know nD , we can
easily calculate the supply of output y S = z(nD )θ and the planned dividend
2.A. A MODEL WITH CAPITAL AND LABOR 51
payment d = y S − wnD . Note that unlike before, firms here will generally earn a
positive profit d > 0, which reflects the return to the capital used in production.
The individual’s choice problem remains as before, except that now house-
holds have two sources of income (wage and dividend income). Given some
arbitrary market wage w, the solution satisfies:
M RS(cD , lD ) = w;
cD = w(1 − lD ) + d.
Once we know lD , we can infer the labor supply function from the time-constraint:
nS = 1 − lD .
Since the market wage w has been arbitrarily chosen at this stage, it is
generally not a market-clearing wage. The next step then is to impose the
market-clearing condition:
nD = nS .
The assumption here is that the real wage adjusts in order to ensure that the
market clears (again, remember that there is only one market in this model).
The model’s general equilibrium is depicted as Point A in Figure 2.12.
The general equilibrium of this model economy differs from the one in the
text in only two minor ways. First, the equilibrium real wage is equal to w∗ =
z(n∗ )θ−1 (it now varies with the equilibrium level of employment). When θ =
1, we once again have w∗ = z. Second, firms actually earn ‘profit’ (generate
dividends) in this model. This profit represents the return to the capital that
is used in production. Since households own the equity in the business sector,
they are also the ultimate owners of capital. The dividend payment reflects this
ownership in the capital stock.
FIGURE 2.12
General Equilibrium
Equilibrium Budget Line
Production Possibilities
Frontier
c* = y* A Slope = -w* = -MPL = MRS
d*
0 l* 1.0
2.B. SCHUMPETER’S PROCESS OF CREATIVE DESTRUCTION 53
2.B Schumpeter’s Process of Creative Destruc-

tion
Capitalism’s Forces of Creative Destruction Unleash Opportunities for

Investors
by Frederick B. Taylor, Vice Chairman and Chief Investment Officer
Updated: 4/9/02
Writing about capitalism more than 50 years ago, economist Joseph Schum-
peter coined the phrase "creative destruction" to describe the process by which
a free-market economy is constantly evolving, as new and better ways of doing
business are introduced and the old and outmoded fall by the wayside. Creative
destruction "revolutionizes the economic structure from within," said Schum-
peter, "destroying the old one, (and) creating a new one." He argued that this
dynamic process was central to capitalist system’s ability to maximize output
and total wealth creation over time.
Creative destruction is not a steady process. While the forces of creative
destruction are always present in a capitalist system, the process often occurs
in intense bursts - "discrete rushes," as Schumpeter termed them, "which are
separated from each other by spans of comparative quiet." Historically, we ex-
perienced a period of intense creative destruction in the late 19th and early 20th
centuries, and we are now living in the midst of another. At the turn of the last
century, the industrial revolution had transformed agricultural economies and
was radically changing most people’s lives. New industrial powers–the United
States and Germany–were developing to challenge the established economies of
England and France. Today, the ongoing revolution in technology and commu-
nications is creating new industries and transforming or eliminating old ones.
New economies are emerging that provide new markets as well as new sources
of competition. Corporate restructuring and privatization of government-owned
enterprises are widespread.
Usually, one can only see what is being destroyed by this process; it is much
more difficult to understand what is replacing it. For example, it was easy
to see carriage and buggy whip manufacturers going out of business with the
advent of the automobile, but much harder to visualize the mega-industry that
would emerge to replace them. Similarly, as manufacturing declined in the U.S.
during the latter part of the 20th century, the displacement of factory workers
was evident long before the creation of jobs in the service sector that reemployed
them.
Although the process of creative destruction can create tremendous oppor-
tunities for investors, it is often difficult to discern them early on, when the
maximum benefit can be gained. However, in our search for value, this is ex-
actly what we strive to do for our clients.
On a global level, those countries where capitalism and the forces of creative
destruction are permitted to flourish create more attractive opportunities for in-
vestors than less dynamic economies. Of course, the United States continues to
be the prime example of relatively unfettered capitalism at work, and the U.S.
economy has been better able not only to withstand, but to thrive amid the
current forces of creative destruction–hence the sustained strong performance
of the U.S. stock market in the 1990s. However, there are other countries that
are also benefiting from the forces of creative destruction, most notably in Eu-
rope. Great Britain was the first to dismantle the government programs that
had hindered its economic growth. As the rest of Europe follows suit, albeit
each country at its own speed, creative destruction will be at work restructur-
ing old inefficient economies into more vibrant, growing ones. In particular,
Ireland, Italy, Portugal, and Spain, which have less rigid economic systems than
France and Germany, are learning to compete effectively in the global economy.
The introduction of the euro and the emergence of Pan-Europeanism are also
expanding markets for companies able to compete effectively in this new envi-
ronment, and the "creative destruction" of national currencies has given birth to
the Euro. A few Latin American countries, most notably Argentina and Chile,
are becoming free-market economies. And in Asia, where we recently witnessed
the destruction of the old status quo, opportunities are beginning to emerge for
innovative companies.
At the root of the creative destruction process are individual companies.
They are the agents of change that develop new products, new technology, new
production or distribution methods, new markets and new types of organization
that will revolutionize the economy. Companies that change the business model
for their industry or develop a new paradigm significantly alter the competitive
landscape. As Schumpeter says, "competition which commands a decisive cost
or quality advantage. . . strikes not at the margins of the profits and the outputs
of the existing firms but at their foundations and their very lives."
We want to own companies that benefit from creative destruction. Good
businesses that are constantly adapting to their changing environment and es-
tablish a decided competitive advantage will generate strong returns for their
shareholders over a long period of time. We search industries throughout the
world to find those companies that are transforming the terms of competition
in their field. The forces of creative destruction in capitalism are not only the
engine of economic growth; they also generate unparalleled investment oppor-
tunities for astute investors.
1. From Joseph A. Schumpeter, History of Economic Analysis, edited from

a manuscript by Elizabeth Boody Schumpeter (New York: Oxford Uni-
versity Press, 1963).
Chapter 3
Fiscal Policy
3.1 Introduction
In this chapter, we extend the basic neoclassical model to include a government
sector that demands some fraction of the economy’s output for some purpose
that we view as being determined exogenously by political factors. Note that
this chapter does not constitute a theory of government. Rather, the theory
developed here is designed to explain how the economy reacts to any given
(exogenous) change in a government’s desire to tax and spend. We continue to
work with a static model, so that the government must balance its budget on a
period-by-period basis (i.e., the government may not run surpluses or deficits).
The issue of deficit-finance will be addressed in a later chapter when we have
the tools to investigate dynamic decision-making.
3.2 Government Purchases

Assume that the government sector ‘demands’ g units of output, where g is
exogenous. There are two ways of viewing the production of output destined
for the government sector. The first way is to suppose that all output y is
produced by the private sector and that the government sector purchases the
output it desires g from the private sector. The second way is to suppose that the
government produces the output it needs by employing workers (public sector
workers). If the government has access to the same technology as the private
sector, then either approach will yield identical results.
Before proceeding further, we need to ask the question: What is g used for?
In reality, government purchases are directed toward a wide variety of uses,
including: bureaucratic services, in-kind transfers (e.g., school lunch programs,
health-care services), military expenditures, and outright theft (politicians lining
55
56 CHAPTER 3. FISCAL POLICY
their own pockets). For some types of expenditures (e.g., those expenditures
that are distributed free of charge to the general population), it would make
sense to think of households viewing g as a close substitute for goods and services
that they might otherwise purchase from the private sector. In this case, one
could model preferences as:
u(c + g, l). (3.1)
In this case, output that is purchased from the private sector and output that is
supplied by the government are viewed as perfect substitutes by the household
(e.g., as is likely the case with school lunch programs). If the school lunches sup-
plied by the government do not exactly correspond to the lunches that parents
would pack for their kids on their own, then might instead specify u(c + λg, l),
with λ ≤ 1. According to this specification, one unit of government supplied out-
put is equivalent to λ units of privately purchased output as far as the household
is concerned.
Alternatively, government expenditures may be allocated toward uses that
do not have very close substitutes in the way of market goods; e.g., military ex-
penditures or a national space program. In this case, one might more reasonably
model preferences as:
u(c, l) + λv(g), (3.2)
where λ ≥ 0 and v is an increasing and concave function. According to this
specification, households may value a national space program not for material
reasons but for ‘psychic’ reasons (e.g., national pride). On the other hand, if
households do not value such expenditures at all (e.g., if g is used to build a
king’s castle, or used to finance an unpopular war), then one could specify λ = 0.
In what follows, we will adopt the latter specification of preferences (3.2) for
the case in which λ = 0. As it turns out, the model’s predictions for economic
behavior will continue to hold even for the case in which λ > 0 (the only thing
that would change is the prediction for economic welfare). On the other hand,
the model’s predictions concerning behavior will generally differ if we adopt the
specification (3.1).
3.2.1 Lump-Sum Taxes

Suppose that government spending is financed with a lump-sum tax τ. A lump-
sum tax is a tax that is placed on individuals that does not vary with the level
of their economic activity. For this reason, it is also sometimes called a ‘head
tax.’ Lump-sum taxes are not that common in reality, but for our purposes, it
serves as a useful benchmark. The key restriction on government behavior is
given by the government budget constraint (GBC), which in this case takes the
form:
τ = g. (3.3)
As it turns out, in our model, the government fiscal policy will have no effect
on the equilibrium wage or profits; i.e., (w∗ , d∗ ) = (z, 0). In general, this result
3.2. GOVERNMENT PURCHASES 57
will not hold, but does so here because of the linearity that we have assumed
in the production function. But the implications of the fiscal policy on output
and employment are not affected by this simplification and so we proceed with
this simple specification.
In order to see how individuals are affected by the fiscal policy, we have to
restate their choice problem. If individuals must pay a lump-sum tax τ, then
their budget constraint is now given by: c = wn − τ. Substituting the time-
constraint n + l = 1 into the budget constraint allows us to rewrite the budget
constraint as: c = w − wl − τ. If the private sector derives no direct utility from
g, then the choice problem of individuals is given by:
Choose (c, l) in order to maximize u(c, l)

subject to: c = w − wl − τ and 0 ≤ l ≤ 1.
The solution to this choice problem is a pair of demand functions: cD (w, τ ) and
lD (w, τ ). Once the demand for leisure is known, one can compute the supply of
labor nS (w, τ ) = 1 − lD (w, τ ).
Since the choice problem of the business sector is unaffected, we know that
the equilibrium wage and dividend payment will equal (w∗ , d∗ ) = (z, 0). As well,
the government budget constraint (3.3) will have to be satisfied in equilibrium.
The model we studied in Chapter 2 is just a special case of the model de-
veloped here (i.e., in the earlier model, we were assuming g = 0). Figure 3.1
displays the general equilibrium of the economy when g = 0 (point A). When
g = 0, the equilibrium budget constraint corresponds to the production possibil-
ities frontier. Suppose now that the government embarks on an ‘expansionary’
fiscal policy by increasing spending to some positive level g > 0. Because the
government spending program requires a tax on individuals, their budget con-
straint moves downward in a parallel manner. If consumption and leisure are
normal goods (a reasonable assumption), then the new general equilibrium is
given by point B in Figure 3.1. Notice that the income-expenditure identity
y = c + g is always satisfied in this economy.
FIGURE 3.1
Expansionary Fiscal Policy
Financed with Lump-Sum Tax
PPF: y = z - zl
Budget Line: c = z - zl - g
y*
A
B
c*
0
l* 1.0 l
-g
The model predicts that an expansionary fiscal policy financed by a lump-sum

tax induces an increase in output and employment. However, the policy also
induces a decline in consumer spending. The basic force at work here is a pure
wealth effect (there is no substitution effect here because the real wage remains
unchanged). In particular, because the after-tax wealth of individuals declines,
they demand less consumption and leisure (assuming that both consumption
and leisure are normal goods). The decline in the demand for leisure implies
that the supply of labor rises. Because firms simply hire all the labor that is
supplied in our model, aggregate employment expands, which is what leads to
an expansion in real GDP.
Note that while this expansionary fiscal policy causes GDP to rise, it makes
our average (model) person worse off (the indifference curve falls to a lower
level). There is an important lesson here: be careful not to confuse GDP with
economic welfare.
3.2. GOVERNMENT PURCHASES 59
3.2.2 Distortionary Taxation
Now, some of you may be asking whether we needed to go through all the trouble
of developing a model to tell us that an increase in g leads to an increase in y.
After all, we know from the income-expenditure identity that y ≡ c + g. Does
it not simply follow from this relationship (which must always hold true) that
an increase in g must necessarily lead to an increase in y? The answer is no.
To demonstrate this claim, let us reconsider the effects of an expansionary
fiscal policy when government spending is financed with a distortionary tax.
A distortionary tax is (as the name suggests) a tax that distorts individual
decisions, since the amount of tax that is paid depends on the level of individual
economic activity. A primary example of a distortionary tax is an income tax
(the amount of tax paid depends on how much income is generated). In reality,
most taxes are distortionary in nature.
With an income tax, the individual budget constraint becomes: c = (1 −
τ )wn, where 0 ≤ τ ≤ 1 now denotes the income-tax rate. Substituting the time-
constraint n + l = 1 into the budget constraint allows us to rewrite the budget
constraint as: c = (1 − τ )w − (1 − τ )wl. Note that the direct effect of the income
tax is to reduce the slope of the individual budget constraint; i.e., the slope is
now given by the after-tax wage rate −(1 − τ )w. We know that when the slope
of the budget constraint changes, there will generally be both a substitution and
wealth effect at work.
Again, the choice problem of the business sector remains unchanged so that
(w∗ , d∗ ) = (z, 0). In equilibrium, the government’s budget constraint must be
satisfied; i.e., the fiscal authority must choose a τ = τ ∗ > 0 that satisfies:
τ ∗ w∗ n∗ = g. (3.4)
Figure 3.2 depicts the original equilibrium when g = 0 (point A) and the
new equilibrium where g > 0 (point B). The position of point B assumes that
the substitution effect dominates the wealth effect (which is certainly plausi-
ble). Observe now that the effect of an expansionary fiscal policy is to cause a
decline in both output and employment. The economic intuition of this result
is straightforward. The increase in government purchases requires an increase
in the income-tax rate, which reduces the after-tax wage rate of individuals.
The tax now has two effects. Because individuals are poorer, they reduce their
demand for both consumption and leisure, so that labor supply increases (this
is the wealth effect). On the other hand, the tax also reduces the price of leisure
(increases the price of consumption), so that individuals substitute out of con-
sumption into leisure, thereby reducing labor supply (this is the substitution
effect). If the substitution effect on labor supply is stronger than the wealth
effect, then the net effect is for employment (and hence output) to fall.
FIGURE 3.2
Expansionary Fiscal Policy
Financed with Income Tax
PPF
Budget Line: c = (1-t)z - (1-t)zl
A
y*
g
c* B
0 l
n*
Observe that it is still true for this economy that y = c + g. What has hap-
pened here, however, is that the increase in g is more than offset by the resulting
decline in c. So while the income-expenditure identity holds true, it is clear that
one can not rely simply on this relation to make predictive statements. This is
because the income-expenditure identity is not a theory (recall the discussion
in Chapter 1).
3.3 Government and Redistribution

In economies like Canada and the United States, government purchases over the
last few decades have averaged in the neighborhood of 20% of GDP; see Figure
1.2. Most of these purchases are allocated toward what one might label ‘pub-
lic’ goods (output designated for mass consumption), such public parks, public
infrastructure (roads, bridges, etc.), public health and education, and national
defense. It is interesting to note, however, that these types of government pur-
chases constitute a relatively small fraction of total government spending. In
3.3. GOVERNMENT AND REDISTRIBUTION 61
Canada, for example, total government spending is very close to 50% of GDP (as
it is in many European countries). Much, if not most, of this additional spending
is in the form of transfer payments to individuals (e.g., unemployment insur-
ance, welfare, pensions, grants, personal and business subsidies, etc.).1 Since
the benefits of such transfers are typically concentrated among specific groups
and since the costs are borne by the general public, such transfers necessarily
involve some amount of redistribution. A cynic might argue that governments
are primarily in the business of robbing Peter to pay Paul.2 An apologist might
argue that government is (or should be) more like Robin Hood (redressing past
injustices). In any case, there is no question that redistribution, for better or
worse, appears to be a primary function of government. The question we wish to
address here is: What are the macroeconomic consequences of policies designed
to redistribute income?
In the present context, the government’s budget constraint is as follows:
Purchases + Transfers = Taxes.
The sum (Taxes - Transfers) is referred to as Net Taxes. Thus, in our formu-
lation of the government budget constraints (3.3) and (3.4), the expenditure
side referred to purchases and the revenue side referred to net taxes. Total
government spending here is defined as purchases plus transfers.
To begin, let us recall our benchmark allocation (y ∗ , l∗ ), which satisfies
M RS(y ∗ , l∗ ) = z and y ∗ = z(1 − l∗ ). Consider now a government policy that
grants each person a lump-sum transfer equal to a units of output. The gov-
ernment finances this transfer with an income tax τ (which we will take as the
exogenous policy parameter). For simplicity, assume that all households are
identical and that g = 0. The household’s budget constraint becomes:
y = (1 − τ )z(1 − l) + a, (3.5)
with 0 ≤ l ≤ 1. The household’s optimal choice (y D , lD ) must lie on this budget

line and must satisfy the condition M RS(y D , lD ) = (1 − τ )z (in the case that
lD < 1).
The government’s budget constraint is given by:
g + a = τ z(1 − l), (3.6a)
where in this example, g = 0. Inserting (3.6a) into (3.5), we see that the equi-
librium household’s choice (y 0 , l0 ) must satisfy:
y 0 = z(1 − l0 ).
1 Note that transfer payments are not counted as part of the GDP since they only serve to
redistribute income (and not create additional value).

2 The behavior of some politicians remind me of a radio ad from an establishment in London
(Ontario) which proclaimed: “Come to Joe Kool’s...where we screw the other guy...and pass
the savings on to you!”
In other words, as with the benchmark allocation (y ∗ , l∗ ), the household’s choice

(y 0 , l0 ) must lie on the PPF. However, the allocation that arises under the
redistribution scheme does not correspond to the benchmark allocation; i.e.,
M RS(y ∗ , l∗ ) = z > (1 − τ )z = M RS(y 0 , l0 ).
From this condition, we can deduce that y 0 < y ∗ and l0 > l∗ , as in Figure 3.3.
FIGURE 3.3
Lump-Sum Transfer Financed
with an Income Tax
A
y*
0
y
B
a0
0 l* l0 1.0
Thus, our theory predicts that economies with ‘generous’ transfer programs
(and high average tax rates to finance such programs) should exhibit relatively
low levels of real GDP and employment. The intuition is simple. First, the
lump-sum transfers reduce labor supply via a pure wealth effect (people do not
have to work as hard to acquire output). Second, the income tax distorts the
relative price of output and leisure. In particular, since the after-tax wage falls,
the relative price of leisure falls so that individuals substitute out of consumption
and into leisure. Both of these forces work to reduce GDP and employment.
In the context of our example above that features a ‘representative’ house-
hold, we see that such a government policy also leads to a reduction in welfare.
3.3. GOVERNMENT AND REDISTRIBUTION 63
However, in a more realistic model that featured different types of households

(e.g., high-skilled versus low-skilled), we would find that some households would
benefit while others would lose. The model’s predictions concerning the effect
on GDP and aggregate employment, however, would remain intact. Note that
when households differ, it becomes very difficult for us to make any definitive
statement about whether such a redistribution program improves ‘social’ wel-
fare. The notion of ‘social’ welfare is ultimately in the eyes of the beholder.
3.4 Problems
1. Suppose that preferences are such that M RS = c/l and that the indi-
vidual’s budget constraint is given by c = w − wl − τ (a lump sum tax).
Derive this person’s labor supply function nS (w, τ ) and explain (provide
economic intuition) how it depends on τ.
2. Periods of war often entail huge increases in government military spend-
ing financed with government bonds (in the context of our model, you
can think of bond-financing as representing a type of lump-sum tax); see
Figure 3.2 for the case of the United States during World War II. Are the
patterns of economic activity in Figure 3.2 consistent with our theory?
Explain. Hint: draw ‘trend’ lines through the data in the diagrams below.
Figure 3.4
GDP and Employment in the
United States During WWII
2000 1040
1000
1800
960
1600
Billions 2000$
Billions 2000$
920
1400 880
840
1200
800
1000
760
Gross Domestic Product Private Consumption
800 720
39 40 41 42 43 44 45 46 47 39 40 41 42 43 44 45 46 47
1400 58000
1200 56000
1000 54000
Thousands of Workers
Billions 2000$
800 52000
600 50000
400 48000
200 46000
Government Spending Employment
0 44000
39 40 41 42 43 44 45 46 47 39 40 41 42 43 44 45 46 47
3. Suppose that preferences are such that M RS = (c/l)1/2 and that the
individual faces a budget constraint c = (1 − τ )w(1 − l). Derive this indi-
vidual’s labor supply function and explain how it depends on τ. Contrast
3.4. PROBLEMS 65
this result with the result in Question 1. Explain why the results here
differ.
4. Does a distortionary tax necessarily imply an adverse effect on labor sup-
ply? Derive the labor supply function for preferences given by M RS = c/l
and a budget constraint c = (1 − τ )w(1 − l). How does an increase in τ
affect labor supply here? Explain.
5. Figure 3.3 displays the allocation that would result under a policy that
distributes a lump-sum transfer financed by an income tax. The text
asserted that the new allocation (B) must lie to the right of the bench-
mark allocation (A). Prove that this must be the case. Hint: Show that
an allocation that lies to the left of (A) must necessarily entail crossing
indifference curves.
Chapter 4
Consumption and Saving
4.1 Introduction
Thus far, we have focussed primarily on what one might term intratemporal
decisions and how such decisions determine the level of GDP and employment at
any point in time. An intratemporal decision concerns the problem of allocating
resources (like time) across different activities within a period. However, many
(if not most) decisions have an intertemporal aspect to them. An intertemporal
decision concerns the problem of allocating resources across time. For example,
deciding how much to consume today can have implications for how much will
be available to consume tomorrow. The decision of how much to invest must
be made with a view as to how this current sacrifice is likely to pay off at some
future date. If a government runs a deficit today, it must have in mind how the
deficit is to be paid off in the future, and so on. Such decisions are inherently
dynamic in nature. In order to understand how such decisions are made, we
need to develop a dynamic model.
In this chapter, we focus on the consumption-savings choice of individuals.
Since any act of saving serves to reduce consumption in the present and increase
consumption in the future, the key decision involves how to optimally allocate
consumption across time. We will study this choice problem within the context
of a two-period model. The basic insights to be gleaned from a simple two-
period model continue to hold true in a more realistic model that features many
periods. In order to focus on the intertemporal aspect of decision-making, we
abstract from intratemporal decisions. In particular, the working assumption
here is that intratemporal decisions are independent of intertemporal decisions.
This assumption is made primarily for simplicity and can be relaxed once the
basic ideas presented here are well understood.
67
68 CHAPTER 4. CONSUMPTION AND SAVING
4.2 A Two-Period Endowment Economy
4.2.1 Preferences
Consider a model economy populated by a fixed number of individuals that

live for two periods. These individuals have preferences defined over time-dated
output (in the form of consumer goods and services). Let (c1 , c2 ) denote an in-
dividual’s lifetime consumption profile, where c1 denotes ‘current’ consumption
and c2 denotes ‘future’ consumption. Note that consumption today is not the
same as consumption tomorrow; they are treated here as two distinct goods. The
assumption that people have preferences for time-dated consumption simply re-
flects the plausible notion that people care not only for their material well-being
today, but what they expect in terms of their material well-being in the future.
In what follows, we assume that there is no uncertainty over how the future
evolves.
A lifetime consumption profile (c1 , c2 ) can be thought of as a commodity
bundle. The commodity space then is defined to be the space on non-negative
commodity bundles and can be represented with a two-dimensional graph. We
make the usual assumptions about preferences; i.e., more is preferred to less,
transitivity, and convexity. We will also make the reasonable assumption that
consumption at different dates are normal goods and that preferences can be
represented with a utility function u(c1 , c2 ). Figure 4.1 depicts an individual’s
indifference curves in the commodity space.
4.2. A TWO-PERIOD ENDOWMENT ECONOMY 69
FIGURE 4.1
Indifference Curves
c2
Direction of Increasing
Utility
0 c1
4.2.2 Constraints
Individuals are endowed with an earnings stream (y1 , y2 ). One can interpret
yj as the real per capita GDP in period j = 1, 2. From Chapter 2, we know
that the level of GDP is determined by an intratemporal decision concerning
the allocation of time to market-sector activities. Because we want to abstract
from intratemporal decisions here, let us assume here for simplicity that these
decisions are exogenously determined. Given these decisions, the individuals
operate as if they are faced with an exogenous earnings profile (y1 , y2 ). This
assumption is reflected in our use of the label: an endowment economy.
The assumption that real per capita GDP is exogenous is not important for
our purpose here. However, we make one more assumption that does turn out
to be important; i.e., that output is non-storable. This is to say that output
can not be held in the form inventory. Nor can it take the form of new capital
goods, like business fixed investment. For this reason, it is perhaps best to think
of output as taking the form of services and perishable goods. We will relax
this assumption in a later chapter that discusses capital and investment.
4.2.3 Robinson Crusoe
Before proceeding to develop the model further, it will be useful to pause a

moment and to ask what the solution to the individual’s choice problem would
look like if that individual was to operate in the world just described above. In
particular, assume that the individual is living alone on an island (like Robinson
Crusoe, in Dafoe’s famous novel). Our Robinson Crusoe is endowed with y1
units of output (e.g., coconuts) today and expects y2 units of output to be
available in the future (coconuts that are due to mature on his trees in the
next period). Remember that we are assuming that coconuts are not storable.
Mathematically, the choice problem is given by:
Choose (c1 , c2 ) to maximize u(c1 , c2 ) subject to: c1 ≤ y1 and c2 ≤ y2 .
The solution to this choice problem is trivial: Choose cD D

1 = y1 and c2 = y2 .
In other words, the best that Crusoe can do is to simply consume his entire
income in each period. This solution is depicted diagrammatically in Figure
4.2.
FIGURE 4.2
Robinson Crusoe
c2
y2
Feasible Set
0 y1 c1
4.2.4 Introducing a Financial Market

Our Robinson Crusoe economy is a metaphor for an environment in which in-
dividuals do not have access to markets (in this case, financial markets). In
reality, individuals do have access to financial markets. A financial market is
a market on which claims to time-dated consumption can be traded. These
claims represent promises to deliver output at specified dates. In what follows,
we assume that promises of this form can be enforced at zero cost. We implic-
itly made the same assumption in Chapter 2, where we thought of individuals
supplying labor in exchange for claims against output; these claims were then
redeemed at the firm that issued them at zero cost (i.e., there was no issue of
a firm reneging on its promises). In the present context, the fact that financial
claims can be costlessly enforced implies that there is no risk of default.
There are two goods in this model economy (current and future consumption)
and hence there can only be one market and one price. On this market, people
exchange claims for time-dated consumption and the rate at which these claims
exchange measures the (relative) price of these two goods. Let R denote the
price of current consumption measured in units of future consumption. That
is, given some market-determined price R, an individual is able to borrow or
lend one unit of c1 in exchange for R units of c2 . For this reason, R is called the
(gross) real rate of interest.1 Note that the act of borrowing or lending current
consumption in a private debt market is equivalent to selling or buying claims
to future consumption.
• Exercise 4.1. You ask your buddy to buy you a beer tonight; in exchange,
you promise to buy him a beer tomorrow night. What is the implicit real
rate of interest in this exchange? Explain how borrowing the one beer
tonight is equivalent to selling a claim against future beer.
In what follows, we shall simply assume that there is a market for risk-free
private debt with an exogenously determined real interest rate R. Later on, we
will discuss the economic forces that determine R, but for now we just take R
as part of the environment.
If individuals have access to a financial market, then they will be faced with
an intertemporal budget constraint (IBC). To derive this constraint, we begin
by defining the concept of saving. Saving can be defined in general terms as
current income minus expenditures on current needs. In the present context,
saving is given by:
s ≡ y1 − c1 . (4.1)
Notice that, generally speaking, saving can be either positive or negative.

If s > 0, then the individual is saving (purchasing bonds); if s < 0, then the
1 The real interest rate is not to be confused with the nominal interest rate. The former
represents the relative price of time-dated output, while the latter represents the relative price
of time-dated money (a topic that will be discussed shortly).
individual is borrowing (selling bonds). Note that a ‘bond’ in the present context
refers to a privately-issued liability (i.e., a personal promise to deliver stuff in
the future).
• Exercise 4.2. When you approach the bank for a loan, you are in effect
offering to sell the bank a bond. True, False, Uncertain and Explain.
If individuals can be expected to make good on their promises, then the

second-period budget constraint is given by:
c2 = y2 + Rs. (4.2)
What this constraint tells us is that the individual’s future consumption spend-
ing cannot exceed the sum of his earnings plus the interest and principal on
any saving. Note that if s < 0, then Rs represents the amount of output that
the individual is obliged to repay his creditors. Also note that since R is the
gross interest rate, the net interest rate is given by r = (R − 1); in other words,
(1 + r) = R. The quantity rs is called ‘interest income’ if s > 0 and is called the
‘interest charges’ if s < 0.
Substituting the definition of saving (4.1) into the second-period budget
constraint (4.2) yields an equation for the budget line:
c2 = Ry1 + y2 − Rc1 . (4.3)
This budget line tells us which combinations of (c1 , c2 ) are budget feasible, given
an endowment (y1 , y2 ) and a prevailing interest rate R. Notice that the budget
line is a linear function, with a slope equal to −R. This budget line is graphed
in Figure 4.3.
FIGURE4.3
Intertemporal Budget Constraint
c2
Ry1 + y2
Budget Line:
c2 = Ry1 +y2 - Rc1
Budget
Feasible Set Slope = - R
y2
0 y1 y1 + R-1y2 c1
One can rearrange the budget line (4.3) in the following useful way:
c2 y2
c1 + = y1 + . (4.4)
R R
The right-hand-side of the equation above is the present value of the individual’s
lifetime earnings stream. This is just a measure of wealth measured in units of
current consumption (and is represented as the x-intercept in Figure 4.3). We
can also measure wealth in units of future consumption; i.e., Ry1 + y2 . This is
called the future value of an individual’s lifetime earnings stream (and is depicted
by the y-intercept in Figure 4.3). Likewise, the left-hand-side of equation (4.4)
measures the present value of the individual’s lifetime consumption spending.
Hence, the intertemporal budget constraint tells us that the present value of
lifetime consumption spending cannot exceed one’s wealth. This constraint
puts an upper bound on the amount that an individual can borrow.
• Exercise 4.3. Consider an individual with an endowment of beer given

by (y1 , y2 ) = (0, 12). That is, the individual has no beer today, but is
expecting a shipment of beer tomorrow. If the (overnight) real rate of
interest is R = 1.20 (a 20% net interest rate), what is the maximum
amount of beer that this person can borrow today?
From the intertemporal budget constraint (4.4), we see that c1 = y1 and c2 =

y2 is budget feasible. Therefore, we can conclude that the IBC always passes
through the endowment point. But unlike the case of Robinson Crusoe, we see
that an individual with access to a financial market is much less constrained
in how he can allocate his consumption over time. In particular, c1 < y1 and
c2 > y2 is possible (by saving), or c1 > y1 and c2 < y2 is possible (by borrowing).
4.2.5 Individual Choice with Access to a Financial Market
For an individual in possession of an endowment (y1 , y2 ) and who is able to

borrow or lend at the interest rate R, the choice problem can be stated mathe-
matically as follows:
c2 y2
Choose (c1 , c2 ) to maximize u(c1 , c2 ) subject to: c1 + R = y1 + R.
The solution to this choice problem is a pair of demand functions (cD D

1 , c2 )
that depend on the parameters that describe the person’s physical and economic
environment; i.e., y1 , y2 , R and u. Once cD
1 is known, one can calculate the
person’s desired saving function sD from the definition of saving (4.1); i.e.,
sD = y1 − cD
1 . The solution is depicted graphically in Figure 4.4 as point A.
FIGURE 4.4
Consumption - Saving Choice
c2
D A
c2
D
Rs
y2
Slope = - R
0 c1
D y1 c1
D
s
There are two mathematical conditions that completely describe point A in
Figure 4.4. First, observe that at point A, the slope of the indifference curve is
equal to the slope of the budget line. Second, observe that point A lies on the
budget line. In other words,
M RS(cD D
1 , c2 ) = R; (4.5)
cD
2 y2
cD
1 + = y1 + .
R R
• Exercise 4.4. Identify the exogenous and endogenous variables of the
theory developed above. What sort of questions can this theory help us
answer?
• Exercise 4.5. Suppose that the utility function takes the following form:
u(c1 , c2 ) = ln(c1 ) + β ln(c2 ), where β ≥ 0 is a preference parameter. Ex-
plain how the parameter β can be interpreted as a ‘patience’ parameter.
In particular, what would β be equal to for an individual who ‘doesn’t
care’ about the future?
• Exercise 4.6. Suppose that preferences are such that M RS = c2 /(βc1 ).
Use (4.5) to derive the consumer demand function cD D
1 . How does c1 depend
on β? Explain.
4.2.6 Small Open Economy Interpretation

Before we move on to investigate the properties of our theory, let me take some
time to explain how it can be re-interpreted in a way that can help us understand
some issues that arise in international trade and finance. The way we can do
this is by assuming that all individuals of a domestic economy are identical.2
Consequently, the variables c and y can be interpreted as per capita quantities.
An economy is said to be open if the residents of a domestic economy are
able to trade with people inhabiting other economies. An economy is said to be
small if the choices made by domestic residents have no measurable impact on
world prices. In the context of the model developed here, the relevant ‘price’ is
the real interest rate R. Thus, in the case of a small open economy, the interest
rate prevailing in world (and hence domestic) financial markets is viewed as
exogenous.
In international economics, the trade balance is defined as domestic output
minus domestic spending, which in the present context is given by:
T Bj ≡ yj − cj ,
for j = 1, 2. For the small open economy depicted in Figure 4.4, the economy is
running a positive trade balance in the current period. That is, since domestic
residents are consuming less than what they produce, the difference is exported
to foreigners (in exchange for foreign bonds).3 In the future period, the economy
is running a negative trade balance (the country is a net importer of goods and
services, which the country finances by ‘cashing in’ its accumulated foreign bond
holdings).
• Exercise 4.7. Demonstrate that T B1 + TR B2

= 0. Hint: use the intertem-
poral budget constraint together with the definition of the trade balance.
Another important concept in international finance is called the current ac-

count position. The current account is defined as total income minus current
expenditures. The current account differs from the trade balance only to the
extent that the GNP differs from the GDP. Recall that the GNP is equal to the
value of domestic production (GDP) plus net income received from foreigners.
In a closed economy, these two values must equal, but they need not be equal
if the economy is open to international trade. In the context of our model, the
current account positions in periods one and two are given by:
CA1 = y1 − cD
1 ;
CA2 = y2 + rsD − cD
2 ,
2 Instructors: we could also assume that individuals have different endowments but that
preferences are homothetic.

3 The trade balance is also referred to as the value of net exports, denoted by N X in the
j
income-expenditure identity studied in Chapter 2.
4.3. EXPERIMENTS 77
where r = (R − 1).That is, since domestic residents have no foreign bonds ma-
turing in period one (by assumption), the current account is equal to the trade
balance (GDP is equal to GNP). However, in period two, domestic residents
earn interest income equal to rs on the foreign bonds that are maturing in that
period.4
Thus, in Figure 4.4, the economy is running a current account surplus. In
other words, the economy is a net exporter of goods and services. Alternatively,
the country is a net importer of foreign bonds, so the country is also running
a capital account deficit (the capital account is simply defined as the negative
of the current account). Notice that CA1 = sD . For this reason, the current
account in this model economy corresponds to net domestic saving. Note that
in the future period, CA2 = −sD (a country that saves in the current period
will dissave in the future period, and vice-versa).
4.3 Experiments
The model developed above constitutes a theory of consumer demand (and
saving). Alternatively, in the context of a small open economy, the theory
explains the determination of aggregate consumer spending and the current
account. This theory takes the following form:
(cD D D
1 , c2 , s ) = f (y1 , y2 , R, u).
Note that one of the benefits of being explicit about the intertemporal as-
pects of decision-making is that we can make a precise distinction between the
effects of transitory, anticipated, and permanent changes in the physical and
economic environment. For example, note that our theory asserts that current
consumer demand should depend not only on current income, but also on the
level of income that is expected in the future.
4.3.1 A Transitory Increase in Current GDP

In Chapter 2, we learned how a positive productivity shock could lead to an
increase in GDP. Imagine here that this productivity shock is transitory (tem-
porary) so that ∆y1 > 0 and ∆y2 = 0. Because this is a small economy, this
productivity shock has no effect on R. How do the people living in our model
economy react to such a development?
We can answer this question with the aid of a diagram. The first step is to
depict the pattern of desired consumption and saving just prior to the shock; this
situation is depicted as point A in Figure 4.5. I have drawn point A such that
4 In the present context, you can think of sD > 0 as the value of domestic capital that is
‘working’ in some foreign country earning an income rsD . Likewise, you can think of sD < 0
as the value of foreign capital employed on domestic soil earning foreigners an income of rsD .
the country is initially running a zero trade balance, but nothing important that
I say below depends on this (feel free to begin with either a positive or negative
trade balance). Now, suppose that ∆y1 > 0. Since ∆y2 = 0, we can depict this
shift as a rightward shift of the endowment (A → B). Since the interest rate is
unaffected, this implies a rightward shift of the intertemporal budget constraint.
Note that the shock has made domestic residents wealthier.
The question now is where to place the new indifference curve. If we make
the reasonable assumption that consumption at each date is a normal good,
then the increase in wealth results in an increase in consumer demand in both
periods; i.e., ∆cD D
1 > 0 and ∆c2 > 0. We can depict such a response by placing
the new indifference curve at a point northeast of the original position; e.g.,
point C in Figure 4.5.
FIGURE 4.5
A Transitory Increase in GDP
c2
C
c2D
Dc2 D
y2
A B
0 y1 y’1 c1
Dc1
D
Dy1
So we see that a transitory productivity shock results in a relatively mild but

prolonged ‘consumption boom.’ Notice that the increase in current consumer
demand is less than the increase in current GDP; i.e., ∆cD 1 < ∆y1 . The ratio
∆cD1 /∆y1 is called the marginal propensity to consume out of current income.
Since ∆cD1 /∆y1 < 1, we see that a one dollar increase in income results in a less
than one dollar increase in current consumer demand when the income shock is
transitory. The extra income that is not consumed is saved. In this model, the
4.3. EXPERIMENTS 79
extra saving takes the form of purchases of foreign bonds (hence, the country
moves to a current account surplus). This increase in saving is used to finance
the higher consumption level that is desired in the future.
The assumption that consumption at each date is a normal good can be
interpreted as a preference for consumption-smoothing. That is, any increase in
wealth will be spread over all periods in the form of higher consumption at every
date. The availability of a financial market allows individuals to smooth their
consumption over time in response to transitory changes in their income (con-
trast this with how Robinson Crusoe would have to react to a similar shock). As
such, one can think of financial markets as supplying a type of ‘shock-absorber’
against transitory income shocks. That is, by saving (or borrowing), individuals
can use financial markets to absorb the impact of transitory income shocks and
in this way keep their lifetime consumption patterns relatively stable.
• Exercise 4.8. Calculate the marginal propensity to consume for Robinson

Crusoe.
• Exercise 4.9. Imagine modifying our model to allow for many time
periods. Explain why, for any given income shock (e.g., ∆y1 = $1000),
the response of current consumer spending is likely to grow smaller as the
time horizon expands.
• Exercise 4.10. In a recent article, John Bluedorn (2002) investigates
how the current account position of small Caribbean and Central Ameri-
can economies react to ‘hurricane shocks.’ Hurricanes are not infrequent
events in these parts of the world. When they hit, they invariably lead
to a transitory decline in real per capita GDP. The author finds that the
current account position of these economies first falls and later increases
in response to a hurricane shock. Is this feature of the data consistent
with our theory? Explain.
• Exercise 4.11. A newspaper article reports the following event with
commentary: “The Canadian economy has just entered a recession (a
transitory decline in GDP). Adding to our problems is the ballooning
current account deficit.” Explain why the ‘ballooning’ current account
deficit is likely a ‘good’ thing. Hint: model the recession as an exogenous
∆y1 < 0 and evaluate economic welfare under two scenarios: one in which
the current account moves into deficit; and one in which the government
prevents domestic residents from selling bonds to foreigners (so that the
current account position remains in balance).
4.3.2 An Anticipated Increase in Future GDP

Imagine now that the residents of our model economy receive news (informa-
tion) that leads them to revise upward their forecast of their future earnings.
Since the sum of these earnings is equal to y2 , we can model such a shock as
∆y1 = 0 and ∆y2 > 0. An example of such an ‘information shock’ could be

what typically seems to happen just before an economy emerges from recession.
Alternatively, one could imagine the arrival of a new technology that is expected
to improve GDP in the near future. How would our model individuals react to
such information?
Again, we can answer this question with the aid of a diagram. The first step
is to depict the pattern of desired consumption and saving just prior to the shock;
this situation is depicted as point A in Figure 4.6. Once again, I have drawn
point A such that the country is initially running a zero trade balance (again,
feel free to begin with either a positive or negative trade balance). Now, suppose
that ∆y2 > 0. Since ∆y1 = 0, we can depict this shift as an upward shift of the
endowment (A → B). Since the interest rate is unaffected, this implies an upward
shift of the intertemporal budget constraint. Note that while the shock leaves
current GDP unchanged, it nevertheless makes domestic residents wealthier.
This example makes it clear why it is important to distinguish between income
and wealth.
The question now is where to place the new indifference curve. Assuming
that consumption at each date is a normal good, then the increase in wealth
results in an increase in consumer demand in both periods; i.e., ∆cD 1 > 0 and
∆cD2 > 0. We can depict such a response by placing the new indifference curve
at a point northeast of the original position; e.g., point C in Figure 4.6.
4.3. EXPERIMENTS 81
FIGURE 4.6
An Anticipated Increase in GDP
c2
y’2
B
D C
Dy2 c2
Dc2
D
y2
A
0 y1 c1
Dc1
D
Here, we see that the anticipated increase in future GDP also results in a
‘consumption boom’ that begins in the current period. The intuition for this
is the same as before: the shock results in a higher level of wealth so that
the consumption-smoothing motive implies that desired consumer spending in
all periods rises. However, note that while consumption responds in a manner
similar to when the economy is hit by a transitory shock, the behavior of savings
is quite different. In particular, this shock causes a decline in domestic saving (so
that the economy moves into a current account deficit position). Anticipating
their higher future earnings, domestics increase their current consumption by
borrowing from (selling bonds to) foreigners. Once again, observe how the
availability of a financial market allows individuals to smooth their consumption
in the face of an income shock.
The example portrayed in Figure 4.6 also reveals another important point.
Notice that while the current account position of this economy has ‘deteriorated’
(to use language that is common in the financial pages of newspapers), the wel-
fare of domestic residents is higher than before. Consequently, we can conclude
that we must be careful in drawing any immediate link between a country’s
current account position and the welfare of its residents.
• Exercise 4.12. You receive some ‘good’ news that your Aunt has just
passed away and left you with a huge inheritance. Unfortunately, you are
able to collect on this inheritance only once you graduate (in the near
future, hopefully). Since you are currently a student, your current income
is rather low and you are subsisting largely on Kraft dinners. Explain
what action you could take to increase your current spending. Assume
that the fact of your future inheritance is perfectly verifiable (by a bank
manager, for example).
An interesting feature of real economies emerging from recession is that

consumer spending often recovers before GDP does. This empirical observation
is often interpreted as evidence that an increase in consumer spending ‘causes’
economic growth. According to our theory, however, the direction of causality
actually works in reverse. That is, the increase in consumer spending today is
caused by the arrival of information that leads individuals to revise upward their
forecast of future income. For example, laid off workers may receive information
that their former employers are planning to rehire in the immediate future. To
the extent that individuals are on average correct in their forecasts, the increase
in consumer spending will preceed the rise in aggregate income.
The example above warns us to be careful in trying to infer causality simply
by looking at correlations in the data. Correlations by themselves are nothing
more than measurements (descriptions) of the data; they do not constitute
theory. Any particular intertemporal correlation may in fact be generated by
what econometricians call reverse causality. To better understand the concept of
reverse causality, think about the behavior of consumers during the Christmas
season. It is an empirical fact that Christmas shopping preceeds Christmas.
However, it would be wrong to conclude on the basis of this correlation that
Christmas shopping causes Christmas. The direction of causality is obviously
reversed.
• Exercise 4.13. Let preferences be such that M RS = c2 /(βc1 ). Solve

for the desired saving rate sD /y1 and explain how the behavior of the
saving rate could be used by econometricians to forecast economic growth
(y2 /y1 ).
4.3.3 A Permanent Increase in GDP

Imagine now that the economy experiences a productivity shock that is expected
to be permanent. A permanent productivity shock can be modeled here as
∆y1 = ∆y2 = ∆y > 0. Notice that a permanent shock to GDP is a combination
of the two shocks studied above.
Again, we can answer this question with the aid of a diagram. The first step
is to depict the pattern of desired consumption and saving just prior to the shock;
this situation is depicted as point A in Figure 4.7. Once again, I have drawn
point A such that the country is initially running a zero trade balance (again,
4.3. EXPERIMENTS 83
feel free to begin with either a positive or negative trade balance). Now, since
∆y1 = ∆y2 = ∆y > 0, we can depict this change as a 450 shift of the endowment
(A → B). Since the interest rate is unaffected, this implies an outward shift of
the intertemporal budget constraint. Once again, the shock makes individuals
wealthier. Note that the increase in wealth is greater than the case in which the
shock to GDP was transitory.
The question now is where to place the new indifference curve. Assuming
that consumption at each date is a normal good, then the increase in wealth
results in an increase in consumer demand in both periods; i.e., ∆cD 1 > 0 and
∆cD2 > 0. Notice that the shift in the consumption pattern is similar to the shift
in the endowment pattern. While this shift need not be precisely identical, for
simplicity assume that it is. In this case, ∆cD D
1 = ∆y and ∆c2 = ∆y. We can
depict such a response by placing the new indifference curve at a point northeast
of the original position; e.g., point C in Figure 4.7.
FIGURE 4.7
A Permanent Increase in GDP
c2
B=C
y’2
Dc2D
y2
A
0 y1 y’1 c1
Dc1D
Once again, the consumption response is similar to the other two experi-
ments. Note, however, that the size of the increase in consumer spending is
much larger here, compared to when the income shock was transitory. In par-
ticular, our theory predicts that the marginal propensity to consume out of
current income, when the income shock is perceived to be permanent, is (ap-
proximately) equal to ∆cD

1 /∆y1 = 1.0. In other words, our theory suggests that
the marginal propensity to consume out of current income depends critically on
whether shocks to income are perceived to be transitory or permanent.
4.3.4 A Change in the Interest Rate
A change in the interest rate changes the slope of the intertemporal budget
constraint, which implies a change in the relative price of current and future
consumption. Whenever a price changes, we know that in general there will
be both a substitution effect and a wealth effect at work, making the analysis
slightly more complicated. As it turns out, what we can say about how indi-
viduals react to a change in the interest depends on whether the individual is
planning to be a borrower or a lender. We will consider each case in turn.
Lenders
Individuals planning to lend are those people who currently have high income
levels but are forecasting a decline in their future income; i.e., y1 > y2 . Individ-
uals who are in their peak earning years (and thus approaching retirement age)
constitute a classic example of people who generally wish to save. Point A in
Figure 4.8 depicts the case of a lender. If the interest rate rises, then current
consumption becomes more expensive than future consumption. The substitu-
tion effect implies that people would want to substitute out of c1 and into c2 .
This applies to both borrowers and lenders. What will differ between the two
cases is the wealth effect.
Observe that the effect of an increase in the interest rate on wealth depends
on how wealth is measured. That is, wealth measured in present value declines,
but wealth measured in future value rises. For a lender, it is appropriate to think
of wealth as increasing with the interest rate. The intuition for this is that when
R rises, the value of current output rises and lenders are those people who are
relatively well endowed in current output. Consequently, the wealth effect for a
lender implies that both c1 and c2 increase. Notice that while the substitution
and wealth effects operate in the same direction for c2 , we can conclude that
cD
2 unambiguously rises. However, the substitution and wealth effects on c1
operate in opposite directions. Thus, cD 1 may either rise or fall, depending on
the relative strengths of these two effects. Nevertheless, we can conclude that
an increase in the interest rate leads to an unambiguous increase in welfare for
lenders.
4.3. EXPERIMENTS 85
FIGURE 4.8
An Increase in the Interest Rate
(Lenders)
c2
B
C
D
c2D
A
y2
0 y1 c1
c1D
Borrowers
Individuals planning to borrow are those who currently have low income levels
but are forecasting higher incomes in the future (i.e., y1 < y2 ). Young individuals
approaching their peak earning years (e.g., university students) constitute a
classic example of people who generally wish to borrow. Point A in Figure 4.9
depicts the case of a borrower.
The substitution effect associated with an increase in the interest rate works
in the same way as before: Individuals would want to substitute out of the more
expensive good (c1 ) into the cheaper good (c2 ). The difference here, relative to
the case of a lender, is in the wealth effect. For a borrower, an increase in
the interest rate lowers the value of the good that borrowers are relatively well
endowed with (future income). Consequently, they are made less wealthy. This
reduction in wealth leads to a decline in both c1 and c2 .
Note that the substitution and wealth effect now operate in the same di-
rection with respect to c1 . Consequently, we can conclude that an increase in
the interest rate leads those who are planning to borrow to scale back on their
borrowing (i.e., increase their saving), so that cD
1 unambiguously declines. On
the other hand, the substitution and wealth effects operate in opposite direc-
tions with respect to c2 . Therefore, cD

2 may either rise or fall depending on the
relative strength of these two effects. In any case, it is clear that borrowers are
made worse off (they are on a lower indifference curve) if the interest rate rises.
FIGURE 4.9
An Increase in the Interest Rate
(Borrowers)
c2
y2
B A
C
c2D D
0 y1 c1
c1D
Of course, everything said here can also apply to a small open economy. In
particular, how a small open economy responds to change in the world interest
rate depends on whether the country is a net creditor or a net debtor nation.
4.4 Borrowing Constraints

The analysis in this chapter assumes that individuals are free to borrow or lend
at the market interest rate. However, in reality, this may not always be the case.
In particular, it is not clear that those wishing to borrow (with the willingness
and ability to pay back their debt) can always do so. Likewise, a country that
wishes to borrow may not always be able to obtain the credit that is desired.
The reasons for why this may be the case are varied, but to the extent that
it is true, then borrowers are said to face borrowing constraints that limit the
amount that can be borrowed.
4.4. BORROWING CONSTRAINTS 87
A skeptic may remark that the world is full of people (and countries) that
would like to ‘borrow,’ while having little intention of paying back their debt.
Or perhaps the intention is there, but some individuals may be overly optimistic
concerning their ability to repay. The point here is that, in practice, it is difficult
to know whether some individuals are truly debt-constrained or whether they
would in fact be violating their intertemporal budget constraint. The challenge
for theorists is to explain why creditors would refuse to lend to people (or
countries) who are in a position to make good on their promise to repay.
One way to think about borrowing constraints is as follows. Every loan
requires collateral in one form or another. Collateral is an asset that serves
to back a loan and measures the ability (not necessarily the willingness) of
an individual to back up promises to repay. In the context of our model, the
collateral for a loan is given by an individual’s (or country’s) future income y2 .
If an individual could pledge y2 as collateral, then the individual would have no
problem in borrowing up to the present value of his collateral; i.e., y2 /R.
But if y2 represents future labor earnings, then there may be a problem
in securing debt by pledging y2 as collateral. In particular, most governments
have passed laws that prevent individuals from using future labor income as
collateral. These restrictions are reflected in laws that make human capital
inalienable.5 What this means is that if an individual borrows resources from
a creditor, then the creditor is legally prohibited from seizing that individual’s
future labor income in the event that the individual refuses to repay his debt.
In effect, the debtor is legally prohibited from using future labor income as
collateral. For example, personal bankruptcy laws allow individuals to discharge
their debt (to private creditors, not government creditors) with virtual impunity.
Understanding this, a rational creditor is unlikely to extend a loan, even though
the debtor has the ability to repay. The same holds true for countries. The only
way to force a nation in default of its loans to repay would be through an act
of war. Understanding this, international creditors may be unwilling to extend
loans to countries with a poor record of repayment, even if the debtor nation
technically has the means to repay its loans.
We can use a familiar diagram to display the effects of borrowing con-
straint. Every individual continues to face an intertemporal budget constraint
c1 + R−1 c2 = y1 + R−1 y2 . Suppose, however, that individuals are free to save
but not borrow. In this case, individuals face an additional constraint: c1 ≤ y1
(they cannot consume more than they earn). Point A in Figure 4.10 displays the
case of a borrower who is able to borrow. Point B shows where this individual
must consume if he is subject to a borrowing constraint.
5 See Andolfatto (2002).

FIGURE 4.10
Borrowing Constraints
c2
B C
y2
0 y1 c1
If the borrowing constraint is binding (i.e., if the individual is at point B),

then two things are immediately clear. First, the individual is clearly worse
off relative to the case in which he is able to borrow (point A). Second, the
marginal propensity to consume out of current income for individuals who are
debt constrained is equal to one (even for transitory income shocks).
Now, let us consider the following interesting experiment. Consider an econ-
omy populated by a current generation of students (with endowment given by
point B in Figure 4.10). Suppose that initially, these students are free to borrow
at interest rate R, so that they attain the point A in Figure 4.10. Clearly, these
students are racking up a lot of student debt. Suppose now that these students
(or their representatives) lobby the government, complaining about their ‘unfair’
levels of debt and how unreasonable it is to expect them to repay it. Bowing
to this pressure, the government passes a law that allows students to default
on their debt. Judging by the high incidence of student debt default in reality,
many students appear willing to take up such an option. By defaulting on their
debt, these students move from point A to point C in Figure 4.10. Clearly, these
students are made better off (at the expense of their creditors — those evil banks
that are owned by...their parents?).
But while the current generation of students is made better off by such a
4.5. DETERMINATION OF THE REAL INTEREST RATE 89
law, the same cannot be said of future generations of students. In particular,

creditors who are burned by the law are unlikely to make the same mistake twice.
Creditors would refuse to extend new loans to new generations of students.
These generations of students must consume at point B, instead of point A.
The preceeding discussion raises many interesting questions. In particular, it
seems clear enough that even though individual labor income cannot be used as
collateral, many individuals are apparently both willing and able to obtain large
amounts of ‘unsecured’ consumer debt. Of course, some of this debt is subject
to default. However, most of it is repaid. The question is why? Similarly,
while some nations (and local governments) occasionally default on their debt
obligations, most do not. Again, the question is why? An obvious reason may be
that by developing a good credit history, an individual (or country) can ensure
that he (it) has access to credit markets in the future. Appendix 4.A provides
a real world example of this principle at work.
4.5 Determination of the Real Interest Rate

Thus far, we have simply assumed that the real rate of interest was determined
exogenously (e.g., given by God or Nature). As far as individuals (or small
open economies) go, this seems like an appropriate assumption to make, since if
decision-making agents are small relative to the world economy, then their indi-
viduals actions are unlikely to affect market prices. That is, from an individual’s
perspective, it is ‘as if’ market prices bounce around exogenously according to
some law of nature.
But it remains true that the real interest rate is a market price and that
market prices are determined, in part, by the behavior of individuals collectively.
In other words, while it may make sense to view some things as being exogenous
to the world economy (e.g., the current state of technical knowledge), it does
not make sense to think of a market price in the same way. It makes more sense
to think of market prices as being determined endogenously by aggregate supply
and demand conditions.
In order to think about what determines the real rate of interest, we will
have to think of things in terms of the world economy, or at the very least, a
large open economy (like the United States). Unlike a small open economy (e.g.,
individuals or small countries), the world economy is a closed economy. Thus,
while it may make sense for an individual country to run a current account
surplus (or deficit), it does not make sense for all countries to run a surplus (or
deficit) simultaneously (unless you believe that some world citizens are trading
with aliens). As far as the world is concerned, the current accounts of all
countries together must sum to zero.
• Exercise 4.14. You and your friend Bob are the only two people on
the planet. If you borrow a case of beer (at zero interest) from Bob and
promise to pay him back tomorrow, then describe the intertemporal pat-
tern of individual and aggregate current account positions in this economy.
A closed economy model is sometimes referred to as a general equilibrium

model. A general equilibrium model is a model that is designed to explain the
determinants of market prices (as well as the pattern of trade). In contrast,
a small open economy is a model in which market prices are viewed as being
exogenous. Such models are sometimes referred to as partial equilibrium models,
since while they are able to explain trade patterns as a function of the prevailing
price-system, they do not offer any explanation of where these prices come from.
4.5.1 General Equilibrium in a 2-Period Endowment Econ-

omy
Consider Figure 4.4. This figure depicts an individual’s desired consumption

(and saving) profile given some intertemporal pattern of earnings (y1 , y2 ) and
given some (arbitrary) real rate of interest R. In this section, we will continue to
view (y1 , y2 ) as exogenous (which is why we call this an endowment economy).
But we now ask the question: “How is R determined...where does it come from?”
In order to answer this question, we will have to reinterpret Figure 4.4 as
depicting the world economy. That is, let us now interpret (c1 , c2 ) as the con-
sumption profile of a ‘representative agent’ and (y1 , y2 ) as the intertemporal
pattern of real per capita output in the world economy. Figure 4.4 then con-
tinues to depict a partial equilibrium. That is, given some arbitrary real rate
of interest R, the ‘average’ world citizen desires to save some positive amount;
i.e., sD > 0.
But clearly, sD > 0 cannot be a general equilibrium. That is, it is impossible
for the world’s net credit position to be anything other than zero. The partial
equilibrium depicted in Figure 4.4 features an excess supply of loanable funds
(excess desired savings). This is equivalent to saying that there is an excess
supply of current output (cD 1 < y1 ) or an excess demand for future output
(cD
2 > y2 ). In this model, everyone wants to save and nobody wants to borrow
given the prevailing rate of interest. Something has to give. It seems natural,
in the present context, to suppose that what has to ‘give’ here is the prevailing
rate of interest. In particular, the excess supply of loanable funds is likely to
drive the market interest rate down (the converse would be true if there was an
excess demand for credit).
Since the net value of consumption loans must be equal to zero, it seems
natural to suppose that the real rate of interest will adjust to the point at which
sD = 0. Note that when sD = 0, we also have cD D
1 = y1 and c2 = y2 . Let R
∗
denote the equilibrium real rate of interest; that is, the rate of interest that sets
sD = 0. This equilibrium interest rate is depicted in Figure 4.11.
FIGURE 4.11
General Equilibrium
c2
A
c*2 = y2
Slope = -MRS(y1 ,y2) = - R*
0 c*1 = y1 c1
s* = 0
Notice that in Figure 4.11, individuals are still thought of as viewing the pre-
vailing interest rate R∗ as exogenous with respect to their own personal decisions
concerning how much to consume and save. In (general) equilibrium, however,
the interest rate must adjust so that all individual decisions are consistent with
each other. Since everyone is the same in this simple model, logic dictates that
the only consistent savings decision is for everyone to choose sD = 0. The only
interest rate that will make sD = 0 an optimal choice is R∗ .6
In this simple endowment economy, total (world) consumption must be equal
to total (world) output; i.e., c1 = y1 and c2 = y2 . Since individuals are opti-
mizing, it must still be the case that M RS = R∗ (notice that the slope of the
indifference curve in Figure 4.11 is tangent to the intertemporal budget con-
straint exactly at the endowment point). Suppose that preferences are such
that M RS = c2 /(βc1 ), where 0 < β < 1. Then since c1 = y1 and c2 = y2 (in
equilibrium), our theory suggests that the equilibrium real rate of interest is
given by: µ ¶
1 y2
R∗ = . (4.6)
β y1
6 The analysis here easily extends to the case of many different individuals or economies.
i ≷ 0
That is, consider a world with N different countries. Then, given R∗ , it is possible for sD
S
for i = 1, 2, ..., N as long as N D
i=1 si = 0.
Equation (4.6) tells us that, in theory, the real rate of interest is determined
in part by preferences (the patience parameter β) and in part by the expected
growth rate of the world economy (y2 /y1 ). In particular, theory suggests that
an increase in patience (β) will lead to a lower real rate of interest, while an
increase in the expected rate of growth (y2 /y1 ) will lead to a higher real rate of
interest. Let us take some time now to understand the intuition behind these
results.
4.5.2 A Transitory Decline in World GDP
Imagine that world output falls unexpectedly below its trend level so that
∆y1 < 0 (the world economy enters into a recession). Imagine furthermore
that this recession is not expected to last very long, so that ∆y2 = 0. Since the
recession is expected to be transitory (short-lived), the unexpected drop in cur-
rent world GDP must lead to an increase in the expected rate of growth (y2 /y1 )
as individuals are forecasting a quick recovery to ’normal’ levels of economic
activity. What sort of effect is such a shock likely to have on the real rate of
interest?
According to our theory, any shock that leads individuals to revise their
growth forecasts upward is likely to put upward pressure on the real rate of
interest. The intuition behind this result is straightforward. Since real incomes
are perceived to be low for only a short period of time, standard consumption-
smoothing arguments suggest that individuals will want to reduce their desired
saving (increase their desired borrowing), thereby shifting a part of their current
burden to the future. If the interest rate was to remain unchanged, then in
aggregate there would be an excess demand for credit (too few savers and too
many borrowers); i.e., sD < 0. In a competitive financial market, one would
expect the excess demand for credit to put upward pressure on the interest
rate. In equilibrium, the interest rate must rise to the point where once again
sD = 0.
Figure 4.12 depicts this experiment diagrammatically. Imagine that the
initial equilibrium is at point A. A surprise decline in current world output
moves the world endowment to point C. If we suppose, for the moment, that the
interest rate remains unchanged, then consumption-smoothing behavior moves
the desired consumption profile to point B. At point B, however, there is an
excess demand for current period consumption; i.e., cD 0
1 > y1 , or equivalently,
an excess demand for credit; i.e., sD < 0. In order to eliminate the excess
demand for credit, the real interest rate must rise so that the credit market
clears; this occurs at point C.
FIGURE 4.12
A Transitory Recession Leads to an
Increase in the Real Rate of Interest
c2
y2 A
C
B
0 y’1 c D y1 c1
1
D
s <0
• Exercise 4.15. Using a diagram similar to Figure 4.12, show that an

increase in the expected growth rate of world GDP brought about by news
that leaves current GDP unchanged, but leads to an upward revision for
the forecast of future GDP, also leads to an increase in the real rate of
interest. Explain.
4.5.3 A Persistent Decline in World GDP

As with individual economies, the growth rate in world real GDP fluctuates over
time. Any given change in the growth rate may be perceived by market par-
ticipants as being either transitory (e.g., lasting for a year or less) or persistent
(e.g., possibly lasting for several years). In the previous subsection, we consid-
ered the case of a transitory increase in the expected rate of growth (brought
about by a transitory decline in the current level of world GDP). There may
be other circumstances, however, in which a change in the rate of growth is
perceived to be longer lasting (persistent). Extended periods of time in which
growth is relatively low (not necessarily negative) are called growth recessions.
Let us now consider the following experiment. Imagine that current GDP
is unexpectedly low, as in the previous experiment. But unlike the previous
experiment, let us now imagine that individuals perceive that the growth rate
is expected to fall. In particular, imagine that the ∆y1 < 0 leads individuals to
revise downward their growth forecasts so that ∆(y2 /y1 ) < 0. According to our
theory, such an event would lead to a decline in the real rate of interest. The
intuition for this is relatively straightforward. That is, even though current GDP
declines, future GDP is forecast to decline by even more, leading individuals
to increase their desired saving (reduce their desired borrowing). The excess
supply of loanable funds puts downward pressure on the real rate of interest.
The opposite would happen if financial markets suddenly received information
that led participants to revise upward their forecasts of world economic growth.
To summarize, our theory suggests that a short-term rise in the real interest
rate is likely to occur in the event of a (perceived) short-term decline in the level
of GDP below trend. On the other hand, to the extent that a recession takes the
form of lower expected growth rates (expected persistent declines in the level of
GDP below trend), the real rate of interest is likely to fall. Conversely, a world
economic boom that takes the form of higher expected growth rates is likely to
result in higher real rates of interest.
4.5.4 Evidence
Figure 4.13 plots the actual growth rate in real GDP for the United States
against a measure of the short-term (one year) real interest rate.7 Since the
United States is a large economy, it seems reasonable to suppose that movements
in this (large) economy are highly correlated with movements in world variables.
According to our theory, the short-term real interest rate should fluctuate in
accordance with the market’s expectation of short-term real growth in GDP.
Unfortunately, measuring the market’s expectation of future growth is not a
straightforward task, making it difficult to test our theory. In the absence of data
on market expectations, the theory can nevertheless be used as an interpretive
device.
From Figure 4.13, we see then that the real interest rate is not a very good
predictor of future growth. Perhaps this is because forecasting future growth
rates is an inherently difficult exercise for market participants. Note that the real
rate of interest was very low (even negative) in the mid-1970s. According to our
theory, market participants were expecting the economic contraction in 1974-75
to last longer than it did. Likewise, note the unusually high interest rates that
occurred during the contractions in the early 1980s. Our theory suggests that
market participants were surprised by the length of the slowdown in economic
growth. On the other hand, both real interest rates and growth rates were high
during the late 1980s and the late 1990s. In these cases, it appears that market
participants correctly anticipated these periods of economic boom. Finally, note
7 The real interest rate measure here was computed by taking the nominal yield on one-year
U.S. government securities and substracting the one-year ahead forecast of inflation based on
the Livingston survey; see: www.phil.frb.org/ econ/ liv/
that according to more recent data, the real interest rate is again in negative
territory, while economic growth appears to be relatively robust. Evidently,
the market is still expecting some short-term weakness in the U.S. economy.
Whether these expectations are confirmed remains to be seen.
Figure 4.13
Growth Rate in Real per Capita GDP (Actual)
and the Real Short-Term Rate of Interest
United States (1970.1 - 2000.3)
15
10
Percent per Annum
-5
-10
GDP Real Interest Rate
-15
1970 1975 1980 1985 1990 1995 2000
Figure 4.14 plots an estimate of the growth rate in (total) world real GDP.8
As argued above, the (expected) growth rate in world GDP is likely a better
measure to use (especially as capital markets become increasingly integrated).
Unfortunately, there is no readily available measure of the real world interest
rate. However, Figure 4.15 plots a measure of the short-term (ex post) real
interest rate, which is based on the U.S., Euro area, and Japanese economies.
8 These numbers are based on Madison’s estimates; see: www. theworldeconomy.org/

statistics.htm
Figure 4.14
World Real GDP Growth
1970 - 2001
7
6
Percent per Annum
1
1970 1975 1980 1985 1990 1995 2000
Figure 4.15
4.6. SUMMARY 97
The striking feature in Figure 4.15 are the very low rates of return realized
in the mid-1970s. Indeed, world growth did turn out to be lower than average
during this period of time. Since the early 1980s, the real interest rate has
fluctuated between one and four percent, tending to fall during periods of slow
growth and tending to rise (or remain stable) during periods of more rapid
growth.
4.6 Summary
Many, if not most, decisions involve an intertemporal dimension. Actions today
can have implications for the future. Any act of saving is necessarily dynamic
in nature. By saving more today, an individual (or country) can consume more
tomorrow. Since saving more today implies less consumption today (for a given
stream of income), the saving decision is related to the choice of how to allocate
consumption expenditures over time. In other words, consumer demand should
also be thought of as involving a dynamic dimension.
With the availability of financial markets, individuals (or small open economies)
are no longer constrained to live within their means on a period-by-period ba-
sis. Instead, they are constrained to live within their means on a lifetime basis.
As such, financial markets provide a type of ‘shock absorber’ for individuals;
allowing them to smooth their consumption in the face of shocks to their in-
come. As a corollary, it follows that desired consumer spending at any point in
time is better thought of as depending on the wealth of the household sector,
rather than on income. Shocks to income may influence consumer spending,
but only to the extent that such shocks affect wealth. From this perspective, it
also follows that the impact of income shocks on consumer demand can depend
on whether such shocks are perceived to be transitory or persistent.
From the perspective of an open economy, aggregate saving is related to a
country’s current account position (or trade balance). A current account sur-
plus is simply a situation where total domestic income exceed total domestic
consumer spending. This difference must therefore reflect the value of net ex-
ports. The converse holds true for a current account deficit. Whether a country
is in a surplus or deficit position reveals nothing about the welfare of domestic
residents. A large current account deficit may, for example, may result from
either a domestic recession or the anticipation of rapid growth in GDP.
The relative price of consumption across time is given by the real rate of
interest. For an individual (or small open economy), one may usefully view the
interest rate as exogenous. However, in the grand scheme of things, interest rates
are just prices that must at some level reflect the underlying structure of the
economy (e.g., preferences and technology). Taking all economies together, net
financial saving must add up to zero. Thus, the interest rate can be thought of
as being determined by the requirement that the sum of desired net (financial)
saving is equal to zero (i.e., that the supply of credit equals the demand for
credit).
4.7. PROBLEMS 99
4.7 Problems
1. Dominica is a small Caribbean nation (population approximately 70,000
people) whose main industry is banana production (26% of GDP and 40%
of the labor force). This island nation is frequently hit by tropical storms,
sometimes of hurricane strength. From Figure 4.16, we see that these
storm episodes are associated with movements in GDP and net exports
below their trend levels. Note as well that private consumption spend-
ing remains relatively stable throughout these episodes. How would you
explain these general patterns in this data?
Figure 4.16
Dominica
Real per capita GDP and Components
1977 - 1996
8000
6000
(Constant 1996 Dollars)
East Carribean Dollars
Tropical Storms and

4000 Hurricane Luis
2000
Hurricane Hurricane
David Hugo
0
-2000
-4000
78 80 82 84 86 88 90 92 94 96
GDP Consumption Net Exports
2. From Figure 4.16, does it appear that the Dominican economy suffers from
‘borrowing constraints?’
3. Suppose that consumer spending rises in the current quarter and that this
is followed by an increase in GDP in the following quarter. Based on
this observation alone, would it be safe to conclude that strong consumer
spending ‘caused’ the rise in future GDP? If your answer is no, explain
why not. If your answer is yes, then explain: (1) what may have caused
consumer spending to rise in the first place; and (2) how this increase in
consumer spending led to a higher GDP.
4. Consider the following quote from a recent commentary by James Arnold

(BBC News): “Consumer spending is certainly the foundation of many
economies. The long boom of the mid to late 1990s was built on buoyant
spending - especially in the US and UK, where service industries have long
replaced manufacturing as the main economic motor. Similarly, the pre-
dicted slump in consumer spending is seen as the main threat now, as the
US attacks (9/11) crunched into an already-vulnerable global economy.”
(Note: the predicted slump in consumer spending did not materialize).
The quote seems to suggest that economic growth is driven by (presum-
ably exogenous) consumer spending. Offer a critique of this perspective.
5. Suppose that preferences are such that M RS = c2 /c1 . Show that the
consumption-output ratio (cD
1 /y1 ) is given by:
µ ¶
cD
1 1 y2
= 1 + R−1 .
y1 2 y1
Explain why the consumption-output ratio is likely to be countercyclical

in an economy subject to transitory productivity shocks, but relatively
stable in an economy subject to permanent productivity shocks. Is the
behavior of the consumption-output ratio for Dominica consistent with
4.8. REFERENCES 101
theory? (see Figure 4.17).
Figure 4.17
Dominca
Real per capita GDP and the
Consumption-Output Ratio
4
3
Percent Deviation from Trend
-1
-2
-3
78 80 82 84 86 88 90 92 94 96
GDP Consumption-Output Ratio
6. Explain why a country’s current account position is a poor measure of

economic welfare.
7. Using a diagram similar to Figure 4.12, show how the real interest rate is
likely to react if the world financial market suddenly receives information
that leads to an upward revision in the forecast of future GDP. Explain.
4.8 References
1. Andolfatto, David (2002). “A Theory of Inalienable Property Rights,”
Journal of Political Economy, 110(2): 382-393.
2. Bluedorn, John (2002). “Hurricanes: Capital Shocks and Intertemporal

Trade Theory,” Manuscript.
3. Fisher, Irving (1930). The Theory of Interest, New York: The Macmillan
Company.
4. Friedman, Milton (1957). A Theory of the Consumption Function, Prince-
ton NJ: Princeton.
4.A. ALEXANDER HAMILTON ON REPAYING THE U.S. WAR DEBT103
4.A Alexander Hamilton on Repaying the U.S.

War Debt
Source: www.clev.frb.org/Annual99/theory.htm#alex
Anyone who has ever spoken the words “just this once” has probably learned
the hard way the problems of a time-inconsistent strategy. Time inconsistency
refers to a situation in which what looks like the best decision from moment to
moment may not produce the best outcome in the long run. That is, the long-
term plans of people and governments often fall apart because people are free to
make decisions that offer instant gratification at any point in time. Indeed, time
inconsistency is a commonly faced problem in the establishment of economic
policy.
After the American Revolution, Alexander Hamilton, as the first U.S. Sec-
retary of Treasury, was given the task of refunding and repaying enormous war
debts. In a report to Congress in 1790, the whole expense of the war was esti-
mated to be $135 million. Of this amount, $5 million was owed to foreigners,
$17 million was owed for supplies paid by certificates, $92 million was owed for
wages and supplies paid for by “cash” redeemable in gold or silver, and $21 mil-
lion was owed by the states. While it was widely agreed that money borrowed
from foreign governments needed to be repaid, many in the new Congress, in-
cluding Thomas Jefferson and James Madison, argued against the repayment of
some obligations to avoid the difficulties that increased taxation would cause.
But Hamilton was committed to establishing the government’s creditworthi-
ness. He knew the dangers of defaulting on debt, or implicitly defaulting by
engineering inflation. Hamilton understood that by taking the expedient course
and defaulting on some holders of the war debt, Congress would cast doubt
on the trustworthiness of the new government to honor its debts. In so doing,
they would inadvertently drive up the cost of credit by reducing the appeal to
investors that the nation so desperately needed. In other words, his model was
time consistent.
Hamilton felt so strongly about his position that he agreed to endorse a plan
for moving the nation’s capital from New York to Washington, D.C., if his debt
repayment plan passed in Congress. Hamilton’s plan did pass, the young nation
established its creditworthiness, and to this day the seat of the U.S. government
shuts down if it snows more than an inch.
4.B Milton Friedman Meets John Maynard Keynes

Many of you have likely already encountered a theory of consumption in your
introductory macroeconomics class called the Keynesian consumption function.
The Keynesian consumption function is often specified as a relationship that
takes the following form:
C = a + bY,
where a > 0 is a parameter that denotes ‘autonomous’ consumer spending, and
0 < b < 1 is a parameter called the marginal propensity to consume. This
consumption function embeds the common sense notion that desired consumer
spending is an increasing function of income, but that a one dollar increase in
income generally results in a less than one dollar increase in consumer demand.
Note that this theory makes no distinction between income changes that are
perceived to be temporary or permanent.
In a debate that occurred decades ago, Milton Friedman (1957) argued that
consumer demand should depend on wealth, not income. According to Friedman,
the consumption function should be specified as:
C = αW,
where α > 0 is a parameter and W denotes wealth. Thus, according to Fried-

man, consumer demand should be proportional to wealth and should only de-
pend on income to the extent that income influences wealth.
We can understand both views by appealing to our theory (which builds on
the early work of Irving Fisher, 1930). In particular, suppose that preferences
are such that M RS = c2 /(βc1 ). Then our theory implies a consumption function
of the following form: µ ¶h
1 y2 i
cD
1 = y1 + .
1+β R
If we let α = 1/(1+β), then we see that our theory is consistent with Friedman’s
y2
hypothesis, since cD
1 = αW, where W = y1 + R .
On the other hand, we can rearrange our consumption function in the fol-
lowing way: µ ¶³ ´ µ ¶
1 y2 1
cD
1 = + y1 .
1+β R 1+β
³ ´¡ ¢ ³ ´
1 y2 1
If we define a = 1+β R and b = 1+β , then we see that our consumption
function also agrees with Keynes; i.e., cD
1 = a + by1 .
While the two theories look similar, they can in fact have very different im-
plications for consumer behavior. For example, consider two individuals that
have the same level of wealth but different lifetime income patterns. The Fried-
man consumption function implies that these two individuals should have the
same level of consumption, while the Keynesian consumption function implies
4.B. MILTON FRIEDMAN MEETS JOHN MAYNARD KEYNES 105
that the person with the higher current income should have higher (current)
consumer demand.
Our theory is consistent with Friedman’s hypothesis when individuals are
not debt constrained. But if individuals are debt constrained, then our theory
supports Keynes’ hypothesis. In any case, our theory is to be preferred over
either because it makes explicit where the parameters a, b and α come from, as
well as stating the conditions under which either hypothesis may be expected
to hold.
4.C The Term Structure of Interest Rates

In reality, securities can be distinguished by (among other things) their term to
maturity. Suppose, for example, that you wish to borrow money to purchase a
home and that you plan to pay off the mortgage in ten years. There are many
ways in which you might go about financing such a purchase. One strategy
would be to take out a 10-year (long-term) mortgage. Such a debt instrument
has a term to maturity that is equal to ten years. Alternatively, one might choose
to take out a one-year (short-term) mortgage and refinance the mortgage every
year for ten years. Each one-year mortgage has a term to maturity equal to one
year. In practice, the interest rate you pay on a one-year mortgage will typically
differ from the interest rate you would pay on a ten-year mortgage. In other
words, ‘short-term’ interest rates typically differ from ‘long-term’ interest rates.
Our model can be extended so that we may distinguish between ‘short’ and
‘long’ term interest rates. To this end, assume that the economy lasts for three
periods and that the endowment is given by (y1 , y2 , y3 ). Here, you can interpret
y1 as the level of current real GDP; y2 as the current forecast of real GDP in the
‘medium’ term; and y3 as the current forecast of real GDP in the ‘long’ term.
Following the logic embedded in (4.6), the real interest rate between any two
adjacent periods must satisfy:
∗ 1 y2
R12 = ;
β y1
∗ 1 y3
R23 = .
β y2
These are the interest rates you would expect to pay if you were to refinance your
∗ ∗
mortgage on a period-by-period basis. In other words, the sequence {R12 , R23 }
represents a sequence of short-term interest rates. Notice that these short-run
interest rates depend on the sequence of short-term growth forecasts in real
GDP.
Using a no-abritrage condition (ask your instructor to explain this), we can
compute a ‘long-run’ interest rate; i.e.,
∗ ∗ ∗ 1 y3
R13 = R12 R23 = .
β 2 y1
∗
Here, R13 represents the total amount of interest you would pay (including
principal repayment) if you were to finance your mortgage with a long-term
debt instrument (i.e., if your mortgage was to come due in two years, instead
of one year). Notice that the total amount of interest you would pay is the
same whether you finance your mortgage on a year-by-year basis or whether
you finance it with a longer-term debt obligation. The annual (i.e., geometric
average) rate of interest you are implicitly paying on the longer-term mortgage
4.C. THE TERM STRUCTURE OF INTEREST RATES 107
is given by:
µ ¶1/2
∗ ∗ 1/2 1 y3
RL = (R13 ) = .
β 2 y1
Notice that this ‘long-run’ interest rate depends on the ‘long-run’ forecast of
real GDP growth.
∗ ∗
The pair of interest rates {R12 , RL } (which are both expressed in annual
terms) is called the term structure of interest rates or the yield curve. As of
∗ ∗
period 1, R12 is the ‘short-run’ interest rate (or yield) and RL is the ‘long-run’
interest rate (or yield). The yield curve is a graph that plots these interest rates
∗ ∗
on the y-axis and the term-to-maturity on the x-axis. The difference (RL −R12 )
is called the slope of the yield curve.
In reality, we observe that short-run interest rates are much more volatile
that long-run interest rates. A simple explanation for this (based on our theory)
is that long-run forecasts of GDP growth are relatively stable whereas forecasts
of short-run growth are relatively volatile (this would be the case, for example,
if there is a transitory component in the GDP growth rate).
Assuming that the long-run growth rate of GDP is relatively stable, the
slope of the yield curve can be used to forecast the likelihood of recession or
recovery. Suppose, for example, that we are in a recession (in the sense that
y1 has in some sense ‘bottomed out.’). In this case, the slope of the yield
curve is likely to be negative. The negative slope of the yield curve is signalling
the market’s expectation of an imminent recovery (i.e., the forecast of near-
term growth (y2 /y1 ) is relatively high). On the other hand, imagine that y1 is
currently near a ‘normal’ level and that the short-run interest suddenly drops
(with long-term rates remaining relatively stable). In this case, the slope of
the yield curve turns positive, signalling the market’s expectation of near-term
weakness in GDP growth.
4.D The Intertemporal Substitution of Labor Hy-

pothesis
In the model studied in the this chapter, time-dated consumption goods (and
services) were viewed as distinct commodities (like apples and oranges). The
relative price of time-dated output is the real interest rate. Changes in the
interest rate, like changes in any relative price, induce people to substitute across
commodities (the substitution effect). For example, an increase in the interest
rate makes current consumption more expensive relative to future consumption,
inducing people to save more (delay consumption to when it is cheaper).
The basic logic of this argument applies not only to consumption, but to
leisure (and therefore labor) as well. To see how this works, let us combine the
model developed in Chapter 2 with the model developed above (for the case of
a small open economy). In particular, assume that individuals have preferences
defined over both time-dated consumption and leisure. Furthermore, suppose
that these preferences take the following form:
u(c1 , l1 , c2 , l2 ) = [ln c1 + λ ln l1 ] + β ln [ln c2 + λ ln l2 ] ,
where λ and β are preference parameters. For these preferences, we can identify
three relevant marginal rates of substitution:
cj
M RS(cj , lj ) = λ ; for j = 1, 2;
lj
1 c2
M RS(c1 , c2 ) = .
β c1
Following Chapter 2, assume that the production function is given by yj =

zj nj and that nj + lj = 1 for j = 1, 2. Recall that in this world, the equilibrium
wage rate in each period will be equal to zj . Therefore, optimizing along the
intratemporal dimension requires:
cj
λ = zj for j = 1, 2. (4.7)
1 − nj
From what we learned in this chapter, if individuals are free to borrow and
lend at the interest rate R, then optimizing along the intertemporal dimension
requires:
1 c2
= R. (4.8)
β c1
These choices will be constrained by an intertemporal budget constraint:
c2 z2 n2
c1 + = z1 n1 + . (4.9)
R R
Equations (4.7), (4.8) and (4.9) constitute four restrictions that must hold
in equilibrium (for a given R). These four equations can be solved the four un-
knowns (cD D ∗ ∗
1 , c2 , n1 , n2 ). Note that the ‘stars’ on the employment levels indicate
4.D. THE INTERTEMPORAL SUBSTITUTION OF LABOR HYPOTHESIS109
that these are ‘general equilibrium’ quantities in the sense that wages are clear-
ing the domestic labor market in each period. Given these employment levels,
the economy’s real GDP flow is determined by yj∗ = zj n∗j , for j = 1, 2. But since
this is a small open economy, there is no requirement for cD ∗
j = yj (in general,
these two variables will not be equal).
Note that since R is exogenous, the equilibrium employment levels (and
hence, the GDP flows) will, in general, depend on R. To see how this might
work, consider equations (4.7), which may be rewritten as:
λc1 = z1 (1 − n1 );
λc2 = z2 (1 − n2 ).
Now, divide the second equation by the first equation to get:

c2 z2 (1 − n2 )
= .
c1 z1 (1 − n1 )
From equation (4.8), we see that (c2 /c1 ) = Rβ. This allows us to rewrite the
equation above as:
z2 (1 − n2 )
Rβ = . (4.10)
z1 (1 − n1 )
Equation (4.10) allows us to identify the substitution effects (but not the wealth
effects) that are at work in this economy.
First, consider what happens if R increases. Equation (4.10) tells us that
either n2 must fall or n1 must rise (or some combination of both). In other words,
an increase in the interest rate has the effect of increasing current employment
(and output) relative to future employment (and output). The basic intuition
here is as follows. The higher interest rate makes it a good time to work, since
by working you can generate income with which you can use to increase your
current saving (since the return to saving is higher). You can then use this
extra saving in the future to enjoy higher levels of leisure (allowing you to work
less in the future). This is one dimension of the intertemporal substitution of
labor hypothesis. the quantitative relevance of this effect in reality appears to
be small.
The second dimension of the intertemporal substitution of labor hypothesis
concerns the effects of transitory versus permanent changes in real wages. A
permanent change in the real wage can be modeled as ∆z1 = ∆z2 . According to
(4.10), a permanent change in the wage has no effect on relative labor supplies
(of course, labor supply may change in all periods owing to a wealth effect).
On the other hand, 4.10) also reveals that transitory changes in the wage are
likely to induce an intertemporal substitution of labor. For example, consider a
temporary increase in the current wage; i.e., ∆z1 > 0 = ∆z2 . The effect of this
change is for workers to increase n1 relative to n2 . In other words, when the
return to labor is perceived to be temporarily high, individuals choose to work
harder today (and rest more tomorrow). This type of intertemporal substitution
may play a significant role in explaining why employment varies so much across
seasons.
Chapter 5
Government Spending and

Finance
5.1 Introduction
In this chapter, we continue with our small open economy analysis and investi-
gate the effects of government spending and finance. This analysis differs from
that of Chapter 3 in that intertemporal dimensions are now explicitly consid-
ered. Among other things, this will allow us to think clearly about the effects of
government budget deficits and surpluses. This is in contrast to the static model
studied in Chapter 3 where we had to assume that the government balanced its
budget on a period-by-period basis.
5.2 The Government Budget Constraint

As in Chapter 3, we do not ask why there is a government; we just assume
that there is one and that it requires resources. Assume that the legislative
branch of the government has in place an expenditure program. We can model
this program as a pair (g1 , g2 ). Notice that when one speaks of ‘an increase in
government spending,’ one has to be careful to specify whether this increase is
temporary, anticipated, or permanent.
Exactly how the government’s expenditure program is to be financed is a
problem that falls on the government’s finance department (e.g., the Department
of Finance in Canada; the Treasury Department in the United States; and the
Ministry of Finance in Japan). Finance departments typically have only one
way in which to secure the resources necessary to finance the government’s
demand for goods and services: taxes. While the finance department can also
111
112 CHAPTER 5. GOVERNMENT SPENDING AND FINANCE
secure resources by borrowing (i.e., by issuing government bonds), to the extent

that these bonds are eventually repaid, they simply constitute future taxes.
Consequently, the problem facing a finance department basically boils down to
one of choosing the appropriate timing of taxes.
Assume, for simplicity, that the finance department can implement lump-
sum taxes (τ1 , τ2 ). One finance plan that could balance the budget is then given
by τ1 = g1 and τ2 = g2 . But if a government has access to a financial market,
it need not balance its budget on a period-by-period basis. In particular, the
government could choose to save or borrow (just like individuals).
Recall from Chapter 4 that we defined ‘saving’ in general terms as current
income minus expenditures on current needs. In the present context, we can
define ‘government saving’ as:
sG ≡ τ1 − g1 . (5.1)
That is, if τ1 > g1 , then the government is bringing in more tax revenue than
it needs to finance current spending requirements. In this case, we say that
the government is running a budget surplus. If τ1 < g1 , then the government’s
tax revenues are not sufficient to meet current spending requirements. In this
case, we say that the government is running a budget deficit. Note that the
government budget deficit (bG ) can be defined as the negative of government
saving; i.e., bG = −sG = g1 − τ1 . You can think of bG as representing the
government bonds that must be issued in order to cover the short fall in tax
revenue.
In the second period, the finance department must set taxes at a level that
cover both expenditures g2 and its debt obligations RbG ; i.e.,
τ2 = g2 + RbG . (5.2)
By substituting bG = g1 − τ1 into (5.2), we derive the following expression:
g2 τ2
g1 + = τ1 + . (5.3)
R R
The expression in (5.3) constitutes the government’s intertemporal budget con-

straint. Notice the resemblance to the household’s intertemporal budget con-
straint in Chapter 4. In particular, the right-hand-side of (5.3) measures the
present value of the tax (revenue) stream; as such, it constitutes the govern-
ment’s wealth. The left-hand-side measures the present value of the govern-
ment’s expenditure program. The intertemporal government budget constraint
does not imply that the government must balance its budget on a period-by-
period basis (although, this is certainly feasible). In particular, a government
may (if it wishes) run a deficit. But to do so, it must at some point in the future
plan to run a surplus—at least, if it plans to make good on its debt obligations.
5.3. THE HOUSEHOLD SECTOR 113
5.3 The Household Sector
Individuals in the household sector face the same decision problem as in Chapter
4, except that they now have a tax obligation (τ1 , τ2 ) to deal with. If we define
yj − τj as disposable income, then private sector saving can be defined as:
sP ≡ y1 − τ1 − c1 ,
with the second-period budget constraint is given by:
c2 = y2 − τ2 + RsP .
Combining these latter two expressions, we can form the individual’s intertem-
poral budget constraint:
c2 (y2 − τ2 )
c1 + = (y1 − τ1 ) + .
R R
It will be convenient to rewrite the household’s intertemporal budget con-

straint in the following manner:
c2
c1 + = W − T,
R
where W = y1 + R−1 y2 denotes gross wealth and T = τ1 + R−1 τ2 denotes the

present value of a household’s tax obligation to the government. Hence, the
term W − T represents the household’s after-tax wealth. The solution to the
household’s choice problem is depicted in Figure 7.1 (point A).
FIGURE 5.1
Individual Choice with Lump-Sum Taxes
c2
y2 - t2
B
A
0 y1 - t1 W-T W c1
There is something important to observe here. If individuals live in a ‘Fried-

man’ world (see Appendix 4.B), then they do not care about the timing of their
tax payments, if changes in the timing result in the same lifetime tax obligation
T. For example, Figure 5.1 depicts two after-tax endowment profiles that result
in the same after-tax wealth; endowment B features high current taxes (but low
future taxes), while endowment C features low current taxes (but high future
taxes). In either case, consumer demand remains at point C. On the other hand,
if individuals live in a ‘Keynesian’ world (i.e., if they are debt constrained), then
the same conclusion will generally not hold (again, see Appendix 4.B). The im-
portance of this distinction will become apparent shortly. In the meantime, we
will operate under the assumption that individuals are not debt constrained.
5.4 The Ricardian Equivalence Theorem

In this section, we ask two related questions. First, how does a cut in taxes
affect consumer demand? Second, does a large government budget deficit pose
any sort of ‘problem’ for the economy? These two questions are related because
cutting taxes generally implies increasing the deficit, at least, to the extent that
program spending (g1 , g2 ) is left unaltered. Another way to ask the question
being posed here is: What are the likely effects of a deficit-financed tax cut?
Deficit-financed tax cuts are sometimes recommended by policy advisors
when the economy is in recession. The reasoning here runs something as fol-
5.4. THE RICARDIAN EQUIVALENCE THEOREM 115
lows. First, we know that increases in consumer demand are often followed by
periods of economic expansion. If consumer spending is an increasing function
of disposable income (e.g., c = a + b(y − τ ) as in Appendix 4.B), then a cut in
taxes will increase the disposable income of the household sector, leading to an
increase in consumer demand and therefore future GDP.
Let us investigate the logic of this argument within the context of our model.
Take a look at the government’s budget constraint (5.3). If we hold the pattern
of government spending (g1 , g2 ) fixed, then a tax-cut today ∆τ1 < 0 must imply
a future tax increase. This is because the deficit incurred today must be repaid
(principal and interest) at some point in the future. The government budget
constraint makes it clear that future taxes must rise by the amount ∆τ2 =
−∆τ1 R > 0.
The key question here is how the deficit-financed tax cut affects the after-tax
wealth of the household sector. Since gross wealth W is fixed by assumption,
after-tax wealth can only change if the present value of the household sector’s
tax liability T changes. The change in the tax liability is given by:
∆τ2
∆T = ∆τ1 + .
R
Observe that since ∆τ2 = −∆τ1 R, it follows that ∆T = 0.
Because the deficit-financed tax cut leaves the after-tax wealth position of the
household unchanged, we can conclude that this program will have absolutely
no effect on aggregate consumer demand. Another way to state this result is to
assert that ‘deficits do not matter.’ The intuition behind this result is straight-
forward. While the current tax cut increases current disposable income of our
model households, these households are also forecasting a future tax hike and
hence a reduction in their future disposable income. The consumption smooth-
ing motive tells us that households would want to react to such a change in the
intertemporal pattern of their disposable income by increasing their current de-
sired saving. By doing so, they can shift the current tax windfall to the future,
where they can use it to pay for the higher taxes in that period. Since after-tax
wealth is left unchanged, households increase their desired saving dollar-for-
dollar with the decrease in public sector saving; i.e., ∆sP = −∆sG = ∆bG . In
other words, all the new bonds that are issued by the government are willing
purchased by the household sector at the prevailing interest rate, leaving desired
national saving unchanged. When these bonds mature in the future, they are
used by households to pay off the higher tax bill.
The conclusion that ‘deficits do not matter’ is a result implied the Ricar-
dian Equivalence Theorem. Loosely speaking, the Ricardian Equivalence Theo-
rem asserts that under some conditions (that we will talk about shortly), taxes
and deficits are equivalent ways of financing any given government expenditure
stream. That is, since deficits simply constitute future taxes, the theorem alter-
natively asserts that the timing of taxes do not matter. Another way of stating
the same thing is that the household sector should not view its government bond
holdings as net wealth since such bonds simply represent a future tax obligation
(Barro, 1974).1
• Exercise 5.1. If the Ricardian Equivalence Theorem holds, then the

timing of taxes ‘do not matter’ in the sense that there is no effect on
consumer demand, desired national saving, the current account and (in a
closed economy) the real rate of interest. However, the timing of taxes does
have implications for the composition of desired national saving (between
the private and public sectors). Explain how.
• Exercise 5.2. True, False or Uncertain and Explain. The Ricardian

Equivalence Theorem states that government spending ‘does not matter.’
(Hint: the answer is False).
The conclusions of the Ricardian Equivalence Theorem are both striking and
controversial, so let us take some time now to examine the assumptions under-
lying these results. The theorem makes an number of important assumptions
(that happen to hold true in our model economy). These assumptions are stated
below:
1. Perfect financial markets. That is, individuals are free to save and borrow
at the market interest rate. In particular, if some individuals are debt-
constrained, then the theorem does not hold. On the other hand, if only
a small number of people are debt-constrained, then the assumption of
perfect financial markets might serve as a reasonably good approximation.
2. ‘Rational’ households. In particular, households must be ‘forward looking’

and understand the government budget constraint. While it is easy to
imagine that there may be ‘irrational’ households operating in the real
world, one would have to question whether these households influence
aggregate expenditure in a quantitatively important way. It is equally
apparent by the fact that households save that they are forward looking.
And judging by the political controversy generated by budget deficits,
it seems hard to believe that households are generally not aware of the
government budget constraint.
3. Lump sum taxes. In particular, the theorem does not hold if the govern-
ment only has access to distortionary taxes. Since distortionary taxes are
the norm in reality, this assumption is potentially a serious one.
4. Long-lived households. What we literally need here is that the planning

horizon of the household is as long as the government’s planning horizon.
Since governments typically live much longer than individuals, one might
question the empirical relevance of this assumption. To see what can ‘go
wrong’ if households have short planning horizons, consider the case of
1 See also: www.garfield.library.upenn.edu/ classics1992/ A1992GX22600001.pdf
5.5. GOVERNMENT SPENDING 117
an individual in retirement. If the government cuts this person’s taxes

today and increases taxes at some point in the distant horizon, then our
retired individual is unlikely to ‘be around’ to settle the higher future tax
bill (he will have cleverly escaped his tax obligation by dying). For such
an individual, a deficit-financed tax cut constitutes an increase in wealth.
On the other hand, while individuals do not live forever, it is conceivable
that households do. Barro (1974) has pointed out that to the extent that
people care about their children, they may want to save the tax cut and
bequest it to their children (who can then use it to pay for the higher
taxes they will face).
The Ricardian Equivalence Theorem clearly makes some strong assumptions,

most of which are literally not true in reality. However, whether an assumption
is literally true or not is not the relevant issue. The relevant question is whether
the set of assumptions serve as good approximations to reality. Whether a
set of assumptions serve as good approximations or not can only be judged by
subjecting the theory to empirical testing.
As it turns out, empirical tests of the Ricardian Equivalence Theorem report
are mixed (try performing a search on Google). Many empirical studies find that
an increase in budget deficits (a decrease in public sector saving) is met by an
increase in private sector saving, as the theorem predicts. However, it is less
clear whether private savings rise dollar for dollar with the decline in government
saving (as the theorem also predicts).
Perhaps the main lesson of the theorem for policy makers is as follows. To
the extent that households increase their saving in response to a deficit-financed
tax cut, such a policy is not likely to be as stimulative as one might expect (if one
was trained to view the world through the lens of the Keynesian consumption
function).
• Exercise 5.3. Explain why the Ricardian Equivalence Theorem is un-

likely to hold in an economy that experiences net immigration flows.
• Exercise 5.4. Demonstrate, with the aid of a diagram, how the Ricardian
Equivalence Theorem will not hold for an economy where individuals are
debt-constrained.
5.5 Government Spending

It is important to understand that while our model implies that government
budget deficits ‘do not matter,’ the same is not true of government spending. In
our model, changes in the government expenditure program (g1 , g2 ) will matter,
at least, to the extent that it alters the after-tax wealth position of the household
sector.
The results of this section can be summarized briefly. First, since we are
working with an endowment economy, changes in (g1 , g2 ) can have no effect on
real output (y1 , y2 ). Any increase in government spending then must ultimately
imply lower levels of private consumer spending. Second, since the Ricardian
Equivalence Theorem holds in our model, we can without loss of generality
assume that τ1 = g1 and τ2 = g2 . That is, since the timing of taxes ‘does not
matter,’ let’s just assume that the government balances its budget on a period
by period basis. In this case, domestic saving corresponds to private sector
saving (since public sector saving will always be equal to zero).
5.5.1 A Transitory Increase in Government Spending
Consider an initial situation in which (g1 , g2 ) = (0, 0) and suppose that house-
holds are initially content with consuming their endowment; i.e., point A in
Figure 5.2 (remember that where you place the initial indifference curve does
not matter). A transitory increase in government spending can be modeled as
∆g1 > 0 and ∆g2 = 0. We are assuming here that ∆τ1 = ∆g1 , but remember
that whether the government finances this increase with higher current taxes or
a deficit (higher future taxes) will not matter.
This fiscal policy shifts the after-tax endowment point to the left (i.e., to
point B). The higher tax burden makes households less wealthy. The consump-
tion smoothing motive (i.e., the wealth effect) implies that generally speaking,
households will react to this fiscal policy by reducing their demand for con-
sumption at all dates; i.e., ∆cD D
1 < 0 and ∆c2 < 0. We can depict this change
in behavior by moving the indifference curve from point A to point C in Figure
5.2.
5.6. GOVERNMENT SPENDING AND TAXATION IN A MODEL WITH PRODUCTION119
FIGURE 5.2
A Transitory Increase in Government Spending
c2
y2 A
B
C
0 y1 - t1 y1 W-T W c1
From Figure 5.2, we see that current consumer spending does not decline by
the full amount of the tax increase. Therefore, private sector (and domestic)
saving must decline. Households react to the transitory increase in spending
(and taxes) by increasing the amount they wish to borrow from foreigners.
By (temporarily) increasing the net imports of goods and services, domestic
consumers can smooth their consumption over time. Of course, the resulting
current account deficit must be matched in the future by a corresponding current
account surplus (domestic households must export goods and services to the
foreign sector to pay back their debt).
• Exercise 5.5. Demonstrate, with the aid of a diagram, the effects of a

transitory increase in government spending financed by a deficit.
• Exercise 5.6. Demonstrate, with the aid of a diagram similar to Figure
5.2, what effect an anticipated increase in future government spending will
have on the current account.
5.6 Government Spending and Taxation in a Model

with Production
The analysis above has assumed that the intertemporal production of output
(y1 , y2 ) is exogenous. We can move a step closer to reality by assuming instead
that the level of production depends on the time-allocation choices made in the
labor market, the way we described in Chapter 2 and Appendix 4.D.
In a two-period model, the preferences of households must be modified to
include time-dated leisure; i.e., u(c1 , l1 , c2 , l2 ). If the production function is linear
in labor; i.e., yj = zj nj for j = 1, 2, then using the arguments developed in
Chapter 2, we know that the equilibrium gross wages in this model economy will
be given by (w1∗ , w2∗ ) = (z1 , z2 ). The household’s intertemporal budget constraint
then depends on whether taxes are lump sum or distortionary. For lump-sum
taxes, the budget constraint is given by:
c2 z2 (1 − l2 ) − τ2
c1 + = z1 (1 − l1 ) − τ1 + ,
R R
and the government budget constraint takes the earlier form:
g2 τ2
g1 + = τ1 + .
R R
If taxes are distortionary, as in a tax on labor earnings, then the budget con-
straint is given by:
c2 (1 − τ2 )z2 (1 − l2 )
c1 + = (1 − τ1 )z1 (1 − l1 ) + ,
R R
and the government budget constraint is given by:
g2 τ2 z2 (1 − l2 )
g1 + = τ1 z1 (1 − l1 ) + .
R R
When taxes are distortionary, we see that taxes will affect the real return to
labor, so that the effect on labor supply will be affected in much the same way
as it would in response to a change in productivity (z1 , z2 ); again, see Appendix
4.D.
5.6.1 Ricardian Equivalence

When taxes are lump sum, the Ricardian Equivalence Theorem continues to hold
in this environment. However, this will not be the case if taxes are distortionary.
To see why, consider what happens if the government decides to implement a
deficit-financed tax cut. In this case, the tax cut today (∆τ1 < 0) stimulates
employment (and hence, output) today so that ∆n∗1 > 0 and ∆y1∗ > 0. The
tax increase expected in the future (∆τ2 > 0) has the opposite effect, so that
∆n∗2 < 0 and ∆y2∗ < 0. Clearly, the timing of taxes does matter here. We can
also see why a large deficit today may elicit some concern on the part of the
population. That is, if people understand that a high deficit today must at
some point be met with higher future taxes, and if these taxes are distortionary,
then people will understand that high deficits today will put a drag on future
economic activity.
5.7. U.S. FISCAL POLICY 121
5.6.2 Government Spending Shocks

When taxes are lump sum, any type of positive government spending shock
will simply serve to reduce the after-tax wealth of the household sector. When
wealth declines, the demand for all normal goods declines so that ∆c∗j < 0 and
∆n∗j > 0. As in Chapter 3, a positive government spending shock (whether
transitory, anticipated, or permanent), will induce an economic boom, ∆yj∗ > 0
for j = 1, 2. Recall, however, that since private consumption and leisure decline,
the increase in output will not necessarily be associated with an improvement
in economic welfare.
When taxes are distortionary, individuals are hit by a ‘double-whammy,’
so to speak. Since higher levels of government spending require higher taxes
at some point, not only do households experience a decline in wealth, but their
decisions become distorted (in an attempt to escape the tax). Since these higher
taxes are distortionary, they may very well lead to a decline in employment
and output (again, see Chapter 3). It is for these reasons that ‘supply side’
economists are critical of large government spending programs.
5.6.3 Barro’s Tax-Smoothing Argument

Suppose that the government’s expenditure program (g1 , g2 ) is fixed in place.
When taxes are lump-sum, the government’s finance department faces a trivial
decision: choose any (τ1 , τ2 ) that satisfies the government’s intertemporal bud-
get constraint. However, when taxes are distortionary, Barro (1979) has pointed
out that it would be optimal for the government to smooth taxes over time. That
is, the government should choose a tax rate that balances not only the govern-
ment’s intertemporal budget constraint, but balances government spending and
revenue on average throughout time. This implies a relatively constant tax rate
and a budget deficit/surplus that fluctuates over time (but balance out over the
long-run).
By smoothing taxes in this manner, the government is in effect smoothing
out (and therefore minimizing) the distortions that its taxes create over time.
For example, if the government requires an extraordinarily high (but transitory)
level of government purchases in one period (say, to finance a war effort), the
tax smoothing argument implies that the government should finance such an
expenditure by issuing bonds rather than by raising taxes to extraordinarily
high levels. The tax rate should be increased slightly (to minimize distortions)
and kept at this higher level until the debt is paid off.
5.7 U.S. Fiscal Policy

There has been much talk recently of George W. Bush’s fiscal policy. In a nut-
shell, this policy appears to entail: (1) tax cuts (in order to stimulate economic
activity); (2) an increase in government spending on the military (to fight the
war on terror); and (3) a decrease in government spending in other areas. I
will not attempt a full analysis of this fiscal program, but will provide some
perspective in the context of the historical pattern of U.S. government spending
and taxation. Figure 6.3 (should be 5.3) plots U.S. government spending and
taxation (as a ratio of GDP) beginning in 1930.
Figure 6.3
U.S. Government Spending and Taxation
1930 - 2008
50
40
Projected
Percent of GDP
30 (2003 - 2008)
20
10
REVENUE SPENDING
0
30 40 50 60 70 80 90 00
Figure 6.3 (should be 5.3) reveals a number of interesting patterns. First,

note that since the end of the second world war, government spending as a ratio
of GDP has remained relatively constant, displaying a moderate rise through
the Carter-Reagan era, and a moderate decrease through the Clinton era. While
I have not plotted it here, one should keep in mind that there has been a secular
decline in the proportion of government spending devoted to the military since
the end of the Korean war (in 1953, military spending was 15% of GDP; in 2000,
military spending was only 4% of GDP). If one is to believe the projections in
the figure, then the Bush proposal for expanded government spending plan (and
associated deficits) pales in comparison to the historical data.
5.8. SUMMARY 123
Also note the sharp rise in government spending during the second world
war (most of which was in the form of military spending). While taxes did
rise significantly during the war, they did not rise anywhere near to the extent
needed to balance the budget. Here, we see Barro’s tax-smoothing argument
at work. That is, to the extent that the war was perceived to be transitory, it
made sense to finance the bulk of expenditures by issuing bonds, rather than
by raising taxes.
5.8 Summary
The intertemporal approach to government spending and finance emphasizes
the fact that a government with access to financial markets is subject to an
intertemporal budget constraint. From this perspective, it is clear that current
budget deficits simply represent future taxes. The intertemporal approach also
makes clear the importance of evaluating fiscal policy as an entire program that
dictates not only current spending and taxation, but the entire future path of
spending and taxation.
In some circumstances, it was shown that for a given expenditure program,
the timing of taxes is irrelevant as long as the government has access to a lump
sum tax instrument. This conclusion, however, is unlikely to hold empirically
because taxes are typically distortionary. When taxes are distortionary, it makes
sense to smooth taxes over time and allow budget deficits to grow during reces-
sions (or periods when government spending requirements are high), followed
by budget surpluses during periods of economic expansion (or periods when
government spending requirements are low).
In the models studied above, government spending has the effect of ‘crowding
out’ private consumption expenditures. Certain types of government spending
shocks were also shown to affect the current account position of a small open
economy. In addition to these effects, government spending is often asserted to
crowd out private investment spending and lead to higher interest rates. These
issues can be explored in later chapters once we have an appropriate theory of
investment developed.
5.9 Problems
1. Consider a small open economy as in Figure 5.2. In that figure, we assumed
that the transitory increase in government spending was financed by an
increase in current taxes. Suppose instead that the government chooses
to finance the current increase in government spending with an increase
in future taxes. Show that the method of finance has no effect on desired
consumer spending or the current account, but serves simply to alter the
composition of national saving.
2. Consider a closed economy with individuals who have preferences given
by M RS = c2 /c1 . Show that the equilibrium real interest rate is given by:
y2 − g2
R∗ = .
y1 − g1
How is the interest rate predicted to react to: (a) a transitory increase in
government purchases; and (b) an anticipated increase in future govern-
ment purchases? Explain.
3. Consider an economy populated by two types of individuals, A and B.
Normalize the total population to unity and let θ denote the fraction of
type A individuals. Type A individuals live for one period only; their
preferences are given by uA (c1 ) = c1 and they have an endowment y1 .
Type B individuals live for two periods; their preferences are given by
uB (c1 , c2 ) = ln c1 + β ln c2 and they have an endowment (y1 , y2 ). The
real rate of interest is fixed at R. Imagine that a government decides
to implement a public pension plan. The government plans to run this
program as follows. In period one, it taxes all individuals an amount τ
and then saves these ‘contributions’ at the interest rate R. In period two,
the government pays out the proceeds Rτ to all (living) individuals. Each
person living in period two receives a payout equal to s = Rτ /(1 − θ).
If g1 = g2 = 0, then the government’s intertemporal budget constraint is
given by:
s
(1 − θ) = τ.
R
The left hand side of the GBC represents the present value of the govern-
ment’s pension liabilities (promises). The right hand side represents the
taxes that are collected in order to cover these liabilities.
(a) Assume for the moment that θ = 0. Explain why the government
pension program has no effect on aggregate consumer demand. Hint:
use the Ricardian Equivalence Theorem.
(b) Now, assume that θ > 0. Show that the aggregate demand for con-
sumption in period one is now increasing in the ‘generosity’ of the
promised payout s. Explain. Why does the Ricardian Equivalence
Theorem not hold here?
5.10. REFERENCES 125
5.10 References
1. Barro, Robert J. (1974). “Are Government Bonds Net Wealth?” Journal
of Political Economy, 82: 1095—1117.
2. Barro, Robert J. (1989). “On the Determination of the Public Debt,”
Journal of Political Economy, 64: 93—110.
Chapter 6
Capital and Investment
6.1 Introduction
The model economies that we have studied so far have abstracted from physical
capital and investment (expenditures on new capital goods). The models devel-
oped in Chapters 4 and 5 did feature savings, but these savings took the form
of purchases (or sales) of financial capital. Financial capital simply represents
claims against the output of other members in society (e.g., claims against the
output of individuals, foreigners, or governments). However, in these previous
chapters we maintained an important assumption; namely, that output is non-
storable. The way to think of physical (as opposed to financial) capital is that it
represents an intertemporal production technology that allows the economy to
‘transport’ output across time. The most obvious example of physical capital is
inventory. But physical capital can also take the form of a factor of production
(like labor).
Most of the physical capital in an economy constitutes durable assets that
produce services that are useful in the production of output (new goods and
services). Examples of such capital include the residential capital stock (which
produces shelter services) and various forms of business capital (office towers,
land, machinery and equipment, inventory, etc.). In most production processes,
both labor and capital are important inputs for the creation of goods and ser-
vices. The goods and services that are produced by these factors of production
can be classified into two broad categories: consumer goods and investment
goods. Investment goods are treated as expenditures on new capital goods (and
include additions to inventory). These goods are produced in order to augment
the existing capital stock. When the capital stock increases, more output can
be produced with any given amount of labor. In this way, an economy may be
able to grow even in the absence of technological progress.
127
128 CHAPTER 6. CAPITAL AND INVESTMENT
6.2 Capital and Intertemporal Production

The production function in this model economy takes the form:
yj = zj F (kj , nj ),
for j = 1, 2. The function F is increasing and strictly concave in both kj and

nj (see Appendix 2.A). For simplicity, let us assume that the time allocation
choice is fixed (exogenous) at (n∗1 , n∗2 ) = (1, 1). Hence, the production function
can be written as zf (k) ≡ zF (k, 1), where the function f is increasing and
strictly concave. All this means is that as we increase the amount of capital
used in production (holding fixed the labor input), the amount of output that is
produced increases. The fact that f is concave means that output increases with
k at a diminishing rate (there are diminishing returns to capital accumulation).
The slope of the production function is called the marginal product of capital,
which we denote here by M P K(k, z) ≡ zf 0 (k). The M P K(k, z) tells us the
extra output that can be produced by increasing capital by a small amount
from k (given the technology parameter z). If the function f is increasing and
concave, then it follows that the M P K is positive and a decreasing function of
k. As well, note that the M P K is an increasing function of z. Figure 6.1 depicts
the production technology for two different levels of technology z 0 > z. Note
that M P K(k, z 0 ) > M P K(k, z) > M P K(k 0 , z).
FIGURE 6.1
Production Technology
and the Marginal Product of Capital
y
z’f(k)
MPK(k,z’)
zf(k)
MPK(k’,z)
MPK(k,z)
0 k k’ k
6.2. CAPITAL AND INTERTEMPORAL PRODUCTION 129
We assume that the economy begins period one with some exogenous amount
of capital k1 > 0. Think of this capital as having been determined by historical
investment decisions. Since k1 and z1 are exogenous, and since we are assuming
that n∗1 = 1 is exogenous, it follows that the current period GDP is exogenous
as well; i.e., y1 = z1 F (k1 , 1) = z1 f (k1 ).
The level of production at any date is imagined to consist of both new
consumer goods and new capital goods. We will assume that the division of
output between consumer and capital goods can be made within a period. The
way to think about this assumption is that it takes firms relatively little time
to reallocate factors of production across different branches of production. This
is not a very realistic assumption to make if the time period is relatively short,
but we make it here primarily for simplicity. The production of new capital
goods serves to augment the future capital stock. Since the future level of
output depends in part on the future capital stock, diverting resources away from
consumption today (toward investment) serves to increase the future productive
capacity of the economy.
The link between the future domestic capital stock and current domestic
investment spending is given by the following identity:
Future Capital Stock = Current Capital Stock + Net Domestic Investment,

(6.1)
where net domestic investment is defined as gross domestic investment less
depreciation. In what follows, I assume (for simplicity) that capital does not
depreciate so that there is no difference between gross and net investment. I also
assume that existing capital can be consumed (e.g., liquidated) after it is used
in production, so that (gross and net) investment spending may conceivably be
negative.
Let xj denote expenditure on new capital goods in period j = 1, 2. Then
utilizing the definition in (6.1), the capital stock in our model economy evolves
over time according to:
k1 > 0 given; (6.2)

k2 = k1 + x1 ;
k3 = k2 + x2 ;
Since this is a two-period model, carrying capital into the third period makes
no sense (if it can be avoided), so that setting k3 = 0 is desirable here. Setting
k3 = 0 implies setting x2 = −k2 < 0, which implies that the entire period two
capital stock will be (liquidated and) consumed.
6.3 Robinson Crusoe

To begin developing ideas, it is useful to return to our Robinson Crusoe economy.
Remember that Robinson Crusoe is a metaphor that describes a situation in
which an individual (or an economy) cannot trade with other individuals (or
economies). In the present context, this assumption rules out the existence of
financial assets (which constitute claims against the output of other individuals
or economies).
Crusoe has preferences defined over time-dated consumption (c1 , c2 ), that for
present purposes, we can interpret as ‘coconuts.’ Coconuts are produced with
two factors of production: coconut trees (capital) and Crusoe’s labor (which
we have fixed at unity). In the current period, Crusoe is endowed with k1
coconut trees (which can be liquidated and consumed). These trees (together
with Crusoe’s labor) produce y1 = z1 f (k1 ) units of new coconuts.
The supply of coconuts can be allocated to one of two uses: consumption or
investment. Investment here means planting coconuts in the ground as seed crop
if x1 > 0 and liquidating existing coconut trees if x < 0. Assume that coconuts
cannot be stored across time as inventory (although, of course, existing coconut
trees survive into the next period). The act of planting coconuts in the ground
constitutes an act of saving, which in this case takes the form of domestic
investment in the island’s coconut plantations. We thus have the following
relation:
c1 + x1 = y1 . (6.3)
Notice that the income-expenditure identity Y ≡ C + I is satisfied for this econ-
omy in the first period. Note as well from the definition of saving s ≡ y1 −c1 , that
all saving in this economy will take the form of domestic capital expenditure.
From equation (6.3), we can calculate the maximum first period consumption
as cmax
1 = y1 + k1 , which can be achieved by liquidating the entire current stock
of capital; i.e., x1 = −k1 . Likewise, the maximum level of investment can be
attained (the minimum amount of consumption) by investing the entire GDP;
i.e., xmax
1 = y1 (so that cmin
1 = 0).
From (6.2), we see that the level of investment today affects the future stock
of productive capital; i.e., k2 = k1 + x1 . This future stock of coconut trees
(together with Crusoe’s future labor) produces y2 = z2 f (k1 + x1 ) units of future
coconuts. Since the economy ends at the end of period two and since existing
coconut trees can be consumed, Crusoe simply consumes everything he can in
the second period; i.e., c2 = y2 + k2 (again, note that the income-expenditure
C + I = Y identity holds, with I = −k2 ).
Since c2 = y2 + k2 = z2 f (k1 + x) + (k1 + x1 ), we can use (6.3) to write:
c2 = z2 f (k1 + y1 − c1 ) + (k1 + y1 − c1 ). (6.4)
This equation is called the production possibilities frontier (PPF). The PPF
defines the combinations of (c1 , c2 ) that are technologically feasible for Crusoe,
6.3. ROBINSON CRUSOE 131
given the parameters y1 , k1 , z2 , the structure of f, and assuming that the existing
capital stock has a liquidation value equal to k1 . In particular, note that the
maximum feasible level of future consumption is achieved by setting c1 = cmin 1 =
0; i.e., cmax
2 = z2 f (k 1 + y1 ) + (k 1 + y1 ). Likewise, the maximum feasible level of
current consumption is achieved by setting c2 = cmin 2 = 0.
The slope of the PPF is given by:
∆c2
= −z2 f 0 (k1 + y1 − c1 ) − 1.
∆c1
The marginal rate of transformation (between c1 and c2 ) is defined as that
absolute value of the slope of the PPF; i.e.,
M RT (c1 , z2 ) ≡ 1 + z2 f 0 (k1 + y1 − c1 ) = 1 + M P K(k2 , z2 ).
The M RT tells us how many additional units of c2 can be attained by sacrificing

one unit of c1 (i.e., diverting current output away from consumption and into
investment). By increasing current investment by one unit, the future capital
stock is increased by one unit. This extra unit of future capital can be consumed
after it yields the added return M P K, so that the extra total future output
available from the one unit of current investment is given by 1 + M P K. For this
reason, you can think of the (expected) future M P K as representing the (net)
rate of return on current investment spending. Figure 6.2 displays the PPF in
a diagram.
FIGURE 6.2
Intertemporal Production
Possibilities Frontier
PPF: c2 = z2f(k1 + y1 - c1) + (k1 + y1 - c1)

max
c2
0
c2
0
Slope = - [1 + MPK(k1 + y1 - c1 , z2)]
0 c1
0
y1 c1
max
0
x1 > 0 k1
Figure 6.2 makes it clear that the availability of capital and investment allows
Crusoe to choose an intertemporal pattern of production of consumer goods and
services. In the endowment economy studied in Chapter 4, the intertemporal
production of consumption was fixed (as an endowment). The availability of
capital k1 implies that Crusoe is now able to consume more than the current
GDP; i.e., c1 > y1 is feasible (by drawing down the existing stock of capital).
As well, the availability of an investment technology implies that Crusoe may
alter the future level of GDP (and future consumption) by allocating resources
away from current consumption toward investment.
Figure 6.2 describes what is possible for Crusoe to attain. But in order
to understand how he actually behaves, we have to consider his preferences for
time dated consumption. Crusoe’s choice problem is to choose the intertemporal
pattern of consumption that maximizes his well-being as measured by u(c1 , c2 )
subject to his constraints. The solution to this choice problem is displayed in
Figure 6.3 as point A.
FIGURE 6.3
Robinson Crusoe
c2max
A
c2*
k2*
y2*
0 c1* y1 c1max
x1* > 0
The solution at point A is characterized by the following two mathematical

conditions:
M RS(c∗1 , c∗2 ) = 1 + M P K(k1 + y1 − c∗1 ); (6.5)
c∗2 = z2 f (k1 + y1 − c∗1 ) + (k1 + y1 − c∗1 ).
The first condition says that the slope of the indifference curve must be equal
to the slope of the PPF; the second condition says that the solution must lie on
6.4. A SMALL OPEN ECONOMY 133
the PPF. Only point A in the commodity space satisfies these two conditions
simultaneously. Once c∗1 is known, the optimal level of (first period) investment
can be easily calculated as x∗1 = k1 + y1 − c∗1 .
6.4 A Small Open Economy

Now that we understand how a Robinson Crusoe economy operates when in-
vestment is possible, let us examine how things change when we open up the
economy to international trade. We alter the environment by supposing that
Crusoe now has access (say, through the internet) to a world financial market
which allows him to borrow or save at the world (and hence domestic) interest
rate R. We treat R as an exogenous variable.
We can organize our thinking by breaking up Crusoe’s choice problem into
two stages. In stage 1, Crusoe chooses a level of domestic investment spending
to maximize his wealth, subject to production possibilities. In stage 2, Cru-
soe chooses his consumption pattern (and hence the net level of international
borrowing or lending) in order to maximize utility subject to his intertemporal
budget constraint.
6.4.1 Stage 1: Maximizing Wealth

Imagine that you are Crusoe and that you are holding a coconut in your hand.
You are thinking about saving this coconut. What are your choices? You could
plant the coconut in the ground (i.e., invest it domestically). Doing so will
increase your future coconut capital by ∆k2 = 1 unit. This extra future capital
will then yield an additional 1 + z2 f (k2 + 1) coconuts in the future. As it turns
out, this additional output is (approximately) equal to 1 + M P K(k2 , z2 ), which
is why we think of the M P K the ‘rate of return on domestic capital investment.’
Alternatively, you could purchase a foreign bond that yields the (gross) in-
terest rate R (or net interest rate r = R − 1).The way that you purchase this
bond is by exporting your coconut to a foreigner in exchange for his promise
to deliver R = (1 + r) coconuts to you in the future. Clearly, if M P K > r,
then you should invest the coconut domestically. If M P K < r, then you should
export the coconut in exchange for foreign bonds.
Now since the M P K depends on the level of domestic investment spending,
it would make sense to adjust investment (the future capital stock) to a point
where:
M P K(k1 + xD1 , z2 ) = r. (6.6)
The way to convince yourself that this must be true, suppose that the condition
does not hold. If M P K > r, then you could profit by borrowing a coconut
from foreigners at interest rate R and planting the coconut domestically. Your
net profit from such a transaction would be M P K − r > 0. Consequently, in
order to profit in this way, you would increase domestic capital spending until
no such profit opportunity remained. Remember that since the M P K falls as
k2 expands, eventually M P K will equal r as k2 (x1 ) is increased. Alternatively,
if M P K < r, then you could profit by scaling back on domestic investment
and lending the resources to foreigners at the higher return r. Your net profit
from such a transaction would be r − M P K > 0. Of course, as you continue
to scale back on domestic investment spending, the M P K rises and eventually
equals r. Therefore, the desired level of domestic investment spending must
equal (6.6) if no such profit opportunities are to be left unexploited. Equation
(6.6) determines the investment demand function xD 1 (as a function of R, k1 and
z2 ); see Figure 6.4.
FIGURE 6.4
Determination of Domestic
Investment Demand
Rate of
Return
1 + MPK(k1 + x1 , z2)
0 x1
D
x1
• Exercise 6.1. Using Figure 6.4, show that the investment demand func-
tion xD
1 (R, k1 , z2 ) is a decreasing function of R and k1 , and an increasing
function of z2 . Explain.
We now move to show formally how the choice of xD 1 maximizes Crusoe’s

wealth. To do this, let us think of Crusoe in his role as a business manager.
As of period one, the business owns k1 units of capital (measured in units of
current output). This capital is used to produce the output y1 = z1 f (k1 ). If the
business spends x1 units of output on investment, then the period ‘cash flow’ is
given by c1 = y1 − x1 . It is useful here to think of c1 as representing the supply
of consumer goods and services in period one. Note that this supply may exceed
y1 if, for example, Crusoe chose to liquidate (transform into consumer goods)
some of his current capital k1 after production.
The investment x1 determines the future capital stock k2 and hence, the
future level of GDP, y2 = z2 f (k2 ). The future ‘cash flow’ (the supply of future
consumption) is therefore given by c2 = k2 + z2 f (k2 ), since k2 will at this point
be liquidated into consumer goods. Since k2 = k1 + x1 = k1 + y1 − c1 , we can
alternatively write the supply of future consumption as:
c2 = (k1 + y1 − c1 ) + z2 f (k1 + y1 − c1 ). (6.7)
Observe that this equation is simply the PPF described in equation (6.4).
Crusoe’s wealth (measured in units of current output) is the present value
of his company’s cash flow; i.e.,
c2
W = c1 + . (6.8)
R
Alternatively, this expression can be rewritten as c2 = RW − Rc1 . As a business
manager, Crusoe’s problem boils down to choosing a sequence of ‘cash flows’ that
maximizes the present value of the business subject to what is technologically
feasible. In mathematical terms, he must choose (c1 , c2 ) to maximize equation
(6.8) subject to the constraint (6.7). The solution (cS1 , cS2 ) is depicted as point
A in Figure 6.5.
FIGURE 6.5
Stage 1: Maximizing Wealth
RW
c2max
S A
c2
S
y2
c2 = RW - Rc1
0 c1S y1 c1
max
W
x1D > 0
Since x1 = y1 − c1 , it follows that the investment demand function is given

by xD S
1 = y1 − c1 . Notice that the slope of the PPF at point A is equal to −R. In
other words, at point A it is true that 1 + M P K(k1 + y1 − cS1 , z2 ) = R, which is
equivalent to (6.6). This proves that the investment demand xD 1 characterized
by condition (6.6) maximizes Crusoe’s wealth.
• Exercise 6.2. Use Figure 6.5 to depict an allocation that lies on the PPF
but does not maximize wealth.
• Exercise 6.3. Use Figure 6.5 to deduce how (cS1 , cS2 ) and xD
1 respond to
an exogenous increase in R. Explain. How does the increase in R affect
wealth measured in present and future value? Explain.
• Exercise 6.4. Reformulate the analysis above under the assumption

that capital depreciates fully after it is used in production. Depict the
solution in a diagram similar to Figure 6.5 and show that M P K = R
with cS2 = y2S = z2 f (xD
1 ).
The magnitude W derived above measures the value of Crusoe’s business

enterprise. In an open economy, his actual wealth may differ from W to the
extent that he holds other financial assets (existing claims against foreigners)
or liabilities (existing claims by foreigners against him). Let bj denote Crusoe’s
net foreign bond holdings (financial claims against foreigners) as of the end of
period j = 0, 1, 2. If bj is positive, then Crusoe is a net creditor to the rest of
world as of the end of period j. If bj is negative, the Crusoe is a net debtor to
the rest of world as of the end of period j. The magnitude b0 denotes Crusoe’s
‘initial’ foreign net asset position. In Chapter 4, we implicitly assumed that
b0 = 0. But if b0 6= 0, then Crusoe’s wealth as of the beginning of period one is
in fact given by W +b0 and the first period GNP is given by GN P = GDP +rb0 .
6.4.2 Stage 2: Maximizing Utility
At this stage, Crusoe simply faces a standard choice problem that we have
already studied at length in Chapter 4. That is, with wealth maximized at
some level W +b0 , Crusoe’s intertemporal consumption demands must maximize
u(c1 , c2 ) while respecting the lifetime budget constraint: c1 + R−1 c2 = W + b0 .
As in Chapter 4, we are free here to place the indifference curve any where
along the intertemporal budget constraint (the exact position will depend on
the nature of his preferences). The location of the indifference curve does not
determine investment or GDP; what it determines is the actual consumption
profile together with the current account position (net domestic saving position)
of the economy. Figure 4.6 displays the solution (cD D
1 , c2 ) to Crusoe’s utility
maximization problem (under the assumption that b0 = 0).
FIGURE 6.6
Stage 2: Maximizing Utility
(Trade Deficit)
RW
S
c2
D
A B
c2
c2 = RW - Rc1
0 c1S c1
D
y1 W
s1D
D
x1
Before proceeding, it will be useful to review some basic national income

accounting for an open economy (without a government sector). First, recall
the income-expenditure identity: y1 ≡ c1 +x1 +nx1 , where nx1 denotes the trade
balance (net exports) in period one. The current account balance is defined as
ca1 ≡ s1 − x1 or ca1 ≡ (b1 − b0 ). The definition of national saving is given by
s1 ≡ y1 + rb0 − c1 . Combining these definitions, it follows that:
ca1 ≡ nx1 + rb0 .
In the special case where b0 = 0, the current account surplus is precisely equal
to the trade balance (in period one). As well, we have:
s1 ≡ x1 + ca1 ;
≡ x1 + (b1 − b0 );
or s1 = x1 + nx1 with nx1 = b1 if b0 = 0.

Now, consider point B in Figure 6.6. Again, remember that the point B in
Figure 6.6 could have been placed anywhere along the budget line. As drawn
in Figure 6.6, Crusoe’s economy has positive net savings in period one; i.e.,
sD D
1 = y1 + rb0 − c1 > 0 (where recall that we have assumed b0 = 0). These
savings, however, are insufficient to finance the entire expenditure on domestic
investment; i.e., sD D
1 < x1 . The difference must be financed by importing output;
D D D
i.e., nx1 = s1 − x1 < 0. These imports are paid for by issuing (selling) bonds
to foreigners; i.e. bD D
1 = nx1 < 0, so that in this example, Crusoe becomes a
net debtor nation in period one. In Figure 6.6, the trade deficit corresponds
to the distance (cD S
1 − c1 ). This foreign debt is repaid (with interest) in period
two, which is why c2 > cD
S
2 . Note that in period two, net exports are given by
nxD 2 = −(1 + r)b D
1 = −(1 + r)nxD1 > 0. The current account surplus in period
two is given by ca2 = nx2 + rbD
D D D D D
1 Since b1 < 0, it follows that ca2 < nx2 (the
.
future current account surplus is smaller than the future trade surplus).
• Exercise 6.5. Using a diagram similar to Figure 6.6, depict an equilib-

rium for a small open economy in which the level of consumption is greater
than current GDP. Depict another equilibrium in with the country runs a
current account surplus.
6.4.3 A Transitory Productivity Shock
We are now ready to examine how our model economy reacts to a variety of
shocks. Here, I will consider a transitory increase in productivity; i.e., ∆z1 > 0
and ∆z2 = 0. The experiment conducted here is similar to the one performed in
Chapter 4 in the context of an endowment economy. To make drawing diagrams
a bit easier, let me assume that capital depreciates fully after use and that
b0 = 0. None of the qualitative conclusions depend on these simplifications.
As before, let us begin with an initial situation in which the economy just
happens (by coincidence) to be running a zero trade balance; this is depicted
as point A in Figure 6.7. That is, initially we have caD D
1 = nx1 = 0. The
effect of a transitory productivity shock is to shift the PPF in a parallel manner
to the right; e.g., so that point A moves to point B. As the interest rate is
exogenous, it remains unchanged, so that point B characterizes the business
sector’s optimal ‘cash flow’ (cS1 , cS2 ). Assuming that both consumption goods
are normal, their demands will increase along with the increase in wealth so
that the new consumption allocation is given by point C.
FIGURE 6.7
A Transitory Productivity Shock
C
Dc2
D
B
A
0 Dc1D
y1 y1’
Dc1
S
Dy1
Recall that domestic investment demand is given by xD S

1 = y1 −c1 . Therefore,
the change in domestic investment spending is given by: ∆x1 = ∆y1 − ∆cS1 .
D
From Figure 6.7, we see that ∆y1 = ∆cS1 > 0, so that ∆xD 1 = 0. In other words,
in a small open economy, a transitory productivity shock has no effect on do-
mestic investment spending. This result is consistent with equation (6.6), which
asserts that investment spending depends on the (expected) future productivity
of capital z2 , but not on the current productivity of capital z1 . This makes sense
since current investment becomes productive only in the future.
Now recall that desired national saving is given by sD D
1 = y1 − c1 . Therefore,
the change in desired national saving is given by: ∆s1 = ∆y1 − ∆cD
D
1 . From Fig-
ure 6.7, we see that ∆y1 > ∆cD 1 > 0, so that ∆s D
1 > 0. This result is consistent
with the consumption-smoothing argument that we discussed in Chapter 4.
Since current investment spending remains unchanged and since future pro-
ductivity is the same, it follows that the future GDP remains unchanged; i.e.,
∆y2S = ∆cS2 = 0 (note that y2S = cS2 if capital depreciates fully after use). Since
∆cD2 > 0, future consumption now exceeds future GDP. This extra consump-
tion is financed by R∆sD 1 ; i.e., the principal and interest earned on the current
increase in national saving.
Since b0 = 0, we know that ca1 = nx1 . We also know that sD D D
1 = x1 + ca1 ,
so that ∆sD D D D
1 = ∆x1 + ∆ca1 . Since we have already established that ∆x1 = 0,
D D
it follows that ∆ca1 = ∆s1 > 0. In other words, the effect of this shock is
to increase the current account surplus (and trade balance). That is, some of
the period’s extra GDP is used to augment current consumption with the rest
used to purchase foreign bonds (which can later be cashed in to augment future
consumption).
• Exercise 6.6. How would this small open economy respond to an an-
ticipated increase in productivity? Explain, using a diagram similar to
Figure 6.7.
6.4.4 A Persistent Productivity Shock
Let us now consider the effect of a persistent productivity shock; i.e., ∆z1 > 0
and ∆z2 > 0. Again, the experiment conducted here is similar to the one per-
formed in Chapter 4 in the context of an endowment economy. Let us continue
to assume that capital depreciates fully after use and that b0 = 0.
As before, let us begin with an initial situation in which the economy just
happens (by coincidence) to be running a zero trade balance; this is depicted
as point A in Figure 6.8. That is, initially we have caD D
1 = nx1 = 0. A persis-
tent productivity shock acts like a combination of a transitory and anticipated
shocks. As such, the PPF shifts to the right (as in the previous experiment) and
to the northwest (as in the previous exercise). Again, the real rate of interest
remains unchanged, so that the business sector’s optimal ‘cash flow’ (cS1 , cS2 )
moves ‘up’ from point A to point B in Figure 6.8 (in fact, point B may end up
either to the right or left of point A). As wealth is now higher, the pattern of
consumer demands shifts to the northeast; i.e., from point A to point C.
FIGURE 6.8
A Persistent Productivity Shock
B C
Dc2S
Dc2D
A
0 y1 y1’
Dc1D
Dc1S
Recall that the change in domestic investment demand is given by: ∆xD 1 =
∆y1 − ∆cS1 . From Figure 6.8, we see that ∆cS1 > ∆y1 > 0, so that ∆xD 1 > 0.
In other words, in a small open economy, a persistent productivity shock leads
to an increase in domestic investment spending. This result is consistent with
equation (6.6), which asserts that investment spending depends positively on
the (expected) future productivity of capital z2 .
Now recall that the change in desired national saving is given by ∆sD 1 =
∆y1 − ∆cD 1 . From Figure 6.8, we see that ∆y 1 ≈ ∆c D
1 > 0, so that the change
in desired national saving is ambiguous (in Figure 6.8, I have drawn things
such that ∆sD 1 ≈ 0). This result is consistent with the consumption-smoothing
argument that we discussed in Chapter 4. That is, higher levels of income today
induce people to save more. On the other hand, since individuals expect higher
incomes in the future, they wish to save less today. Which effect dominates
depends on the nature of preferences and the size of z2 relative to z1 .
Since current investment spending increases along with (expected) future
productivity, the model predicts that the (expected) future GDP should in-
crease; i.e., ∆y2S = ∆cS2 > 0. Notice here that ∆cS2 > ∆cD
2 > 0, so that future
consumption now falls short of future GDP. Evidently, some of the extra future
output must be used to pay back the added foreign debt accumulated in period
one.
Since b0 = 0, we know that ca1 = nx1 . We also know that sD D D
1 = x1 + ca1 ,
D D D D
so that ∆s1 = ∆x1 + ∆ca1 . Since we have already established that ∆x1 > 0
and ∆sD D D
1 ≈ 0, it follows that ∆ca1 ≈ −∆x1 < 0. In other words, the effect
of this shock is to reduce the current account surplus (and trade balance), so
that the economy experiences a trade deficit. That is, since national savings do
not change very much, the bulk of the extra investment spending is ultimately
financed with imports of capital goods (the sale of bonds to foreigners).
6.4.5 Evidence
Mendoza (1991) documents the following facts for small open economies. First,
the correlation between national saving and investment is positive. Second, na-
tional saving does not fluctuate as much as investment. Third, the trade balance
is countercyclical (tends to move in the opposite direction of GDP over the cy-
cle). He also shows that these basic facts are consistent with the predictions of
a neoclassical model subject to persistent productivity shocks. While his model
is considerably more complicated that the one developed above, the same basic
idea there is at work here.
In particular, imagine that a persistent productivity shock hits our model
economy. Imagine that the shock is such that ∆z1 > ∆z2 > 0 (i.e., the effect of
the shock is strongest in the period it hits, but then tends to die out over time).
According to our model, the anticipation of higher future productivity (∆z2 > 0)
should lead to an investment boom. The current productivity shock (∆z1 > 0)
results in an increase in current GDP (so that investment is procyclical, as it
is in the data). Since the current shock is stronger than the anticipated shock,
desired national saving should increase, but not by as much as the increase
in desired investment. Thus, fluctuations in national saving should be smaller
than fluctuations in investment. Furthermore, since saving does not increase as
much as investment, the trade balance must fall (i.e., it moves in the opposite
direction as GDP).
6.5 Determination of the Real Interest Rate

We have already discussed the determination of the interest rate in the context
of the endowment economy studied in Chapter 4. Many of the basic insights de-
veloped there continue to hold here. Recall that in an open economy endowment
economy, national saving is (by definition) given by:
s1 ≡ ca1 .
In a closed economy, the interest rate must adjust to a point such that caD ∗
1 (R ) =
0, so that sD1 (R ∗
) = 0.
FIGURE 6.9
National Saving and Investment
Saving
Investment
A s1D(R , z1 , z2)
s1* = x1* C
B x1D(R , z2)
D
0 R0 R* R
In an open economy model with investment, however, national savings is (by

definition) given by:
s1 ≡ x1 + ca1 .
In a closed economy, the interest rate must again adjust to a point such that
caD ∗
1 (R ) = 0. However, from the accounting definition above, we see that na-
tional savings can (and generally will be) positive, since savings can now be
used to finance domestic investment expenditure. So, another way at looking
at the determination of the interest rate is to think of R as adjusting to a point
at which desired saving is just equal to desired investment; i.e.,
sD ∗ D ∗
1 (R , z1 , z2 ) = x1 (R , z2 ).
So, in terms of a diagram, we can think of depicting the economy as in Figure

6.9.
Suppose that the interest rate is exogenously determined by R0 (small open
economy scenario). Then the economy in Figure 6.9 will be running a current
account deficit (the difference between points A and B). Note that point A
corresponds to the same point A in Figure 6.6. Likewise, point B corresponds
to the same point B in Figure 6.6.
Now, if this economy was closed to international trade, then there would be
an excess demand for credit if the interest rate remained at R0 (the demand for
investment exceeds the supply of saving). The competition for loans would put
upward pressure on the real interest rate. In a general equilibrium, the interest
rate would be given by R∗ (where the supply of saving just equals the demand
for investment at point C).1
The general equilibrium can alternatively be characterized with a diagram
similar to Figure 6.3 (except that here we are assuming that capital depreciates
fully). In Figure 6.10, point C corresponds to point C in Figure 6.9.
FIGURE 6.10
General Equilibrium
C
y2* = c2*
Slope = - R*
0 c1* y1
s1* = x1*
Note that while the addition of capital and investment complicates the model
beyond what was developed in Chapter 4, it does not alter the qualitative pre-
dictions concerning the effect of productivity shocks on the interest rate (show
this as an exercise).
6.6 Summary
Capital is a durable asset which produces services that, together with labor,
contributes to the production of an economy’s GDP. The economy’s capital
1 Point D represents the general equilibrium in an endowment economy (where there is no
investment demand function).

6.6. SUMMARY 145
stock grows when the level of net investment is positive. The availability of an
investment technology allows an economy to choose the intertemporal pattern of
production. The availability of an investment technology also allows an economy
to smooth its consumption patterns even in the absence of a financial market.
In a small open economy, the level of investment is determined primarily by
the expected productivity of capital investment, together with the prevailing real
interest rate. The current account position (and hence, net domestic saving) in
a small open economy adjusts primarily to accommodate desired consumption
patterns. As in the endowment economy, a ‘deterioration’ of a country’s current
account position may be associated with either an increase or decrease in the
general level of welfare. Whether welfare improves or not depends on the nature
of the shock hitting the economy. For example, a recession that leads to a
transitory decline in GDP will lead to a decline in the current account position,
as would an investment boom caused by a sudden improvement in the expected
productivity of domestic capital spending.
To the extent that modern economies are integrated, the real rate of interest
depends on both the world supply of credit and the world demand for invest-
ment. Shocks that affect large countries or large regions of the world may lead
to a change in the structure of world interest rates. The model developed in this
chapter should be viewed as presenting a rough guide as to the economic forces
that are likely to influence the structure of real interest rates prevailing in world
financial markets. One should keep in mind, however, that in reality there are
many different types of interest rates. There are ‘short’ and ‘long’ rates; ‘real’
and ‘nominal’ rates; and ‘risky and risk-free’ rates. Some of these interest rates
may be influenced primarily by local conditions.
6.7 Problems
1. Imagine that a small open economy is subject to transitory changes in
productivity. Using a diagram similar to Figure 6.9, demonstrate how
the supply of saving and the demand for investment functions fluctuate
with these disturbances. Does the trade balance behave in a procyclical
or countercyclical manner? Explain. Is this consistent with the evidence?
2. Repeat question 1, except now imagine that the productivity shocks are
persistent.
3. If a shock hits the economy that sends the trade balance into deficit, does
this necessarily imply that economic welfare declines? Explain.
4. Repeat questions 1 and 2 in the context of a closed economy and explain
how the real interest rate is predicted to behave. Make sure to provide
economic intuition for your results.
6.8 References
1. Mendoza, Enrique G. (1991). “Real Business Cycles in a Small Open
Economy,” American Economic Review, 81(4): 797—818.
Chapter 7
Labor Market Flows and

Unemployment
7.1 Introduction
In this chapter, we take a closer look at the market. In previous chapters, we
concerned ourselves with the determination of level of employment and cyclical
fluctuations in the level of employment. Any change in the level of employment
constituted net changes in employment (or hours worked). The data reveals,
however, that net changes in employment are small relative to the gross flows
of individuals that move into and out of employment. A zero net change in
employment, for example, is consistent with one million workers finding jobs
and one million workers losing jobs. In other words, individual employment
patterns fluctuate a great deal more than the aggregate (the sum of all individual
employment patterns). This chapter presents some data on gross worker flows
and develops some simple theory to help us interpret this data.
7.2 Transitions Into and Out of Employment

Many countries have statistical agencies that perform monthly labor force sur-
veys that measure various aspects of labor market activity.1 In these surveys,
a person is labeled as employed if they report having done any work during
the reference period of the survey. If a person is not employed, they are then
labeled as nonemployed. Figure 7.1 summarizes the average stocks of employed
and nonemployed individuals in Canada over the sample period 1976—1991 (see
Jones, 1993). The figure also records the average monthly flows of workers into
1 For example, the Labour Force Survey in Canada and the Current Population Survey in
the United States.
147
148 CHAPTER 7. LABOR MARKET FLOWS AND UNEMPLOYMENT
and out of employment.
FIGURE 7.1
Average Labor Market Stocks and Flows
Canada 1976 - 1991 (Jones, 1993)
480,000 per month
Employment Nonemployment
11,100,000 7,708,000
465,000 per month
Over the sample period 1976—1991, the net monthly change in employment
averaged only 15, 000 persons (due mostly to population growth and an increase
in female labor market participation). Notice how small the net change in
employment is relative to the monthly gross flows; i.e., in a typical month,
almost one million individuals flow into or out of employment. The existence of
large gross flows that roughly cancel each other out is evidence that individuals
are subject to idiosyncratic shocks (changes in individual circumstances) that
roughly cancel out in the aggregate. In other words, even in the absence of any
aggregate shocks (a shock that effects most people in the same way—as in earlier
chapters), it appears that individuals are subject to a considerable amount of
uncertainty in the labor market.
How are we to interpret the apparent ‘instability’ of employment (from an
individual’s perspective)? Is the labor market simply a huge game of ‘musi-
cal chairs?’ Should the government undertake job creation programs (i.e., at-
tempt to increase the number of ‘chairs’) to reduce the amount of labor market
turnover? Is labor market turnover a good thing or a bad thing? To answer
these questions, we need to develop a model of labor market transitions.
7.2. TRANSITIONS INTO AND OUT OF EMPLOYMENT 149
7.2.1 A Model of Employment Transitions

Consider a model economy consisting of a fixed number of individuals who have
preferences defined over consumption and leisure (c, l) given by:
u(c, l) = ln(c) + vl, (7.1)
where v ≥ 0 can be interpreted as either a preference parameter measuring the

value of leisure, or as a productivity parameter measuring the productivity of a
home-production technology. Assume that people differ in their ‘leisure value’
parameter v. Notice that the utility of consumption c is given by the natural
logarithm ln(c). The natural logarithm is an increasing and concave function
with the property that as c approaches zero, ln(c) approaches negative infinity.
These properties imply the following reasonable features associated with the
utility of consumption: (1) utility is increasing in the level of consumption
(more is preferred to less); (2) utility increases at a decreasing rate (diminishing
marginal utility of consumption); and (3) very low levels of consumption are
very painful (utility approaches negative infinity).
People also differ in their skill levels. If the market price of one’s labor is
related to one’s skill (a reasonable assumption), then individuals will also face
different potential wage rates w. Let me also assume (again, quite reasonably)
that individuals have different levels of financial wealth, from which they gener-
ate nonlabor income a. Thus, at any point in time, an individual is characterized
by an endowment (w, a, v). Assume that individuals face idiosyncratic risk in
their endowments, so that elements of (w, a, v) fluctuate randomly over time.
Finally, assume that these risks cancel out in the aggregate (so that there is no
aggregate risk).
As in Chapter 2, individuals are endowed with one unit of time. Let n denote
the time that an individual allocates to the labor market. Then individuals are
assumed to face the budget constraint:2
c = wn + a. (7.2)
Inserting this budget constraint into (7.1) together with the time constraint
l = 1 − n allows us to rewrite the objective function as:
V (n) = ln(wn + a) + v(1 − n). (7.3)
Hence, the individual’s choice problem boils down to choosing an appropriate

allocation of time n (just as in Chapter 2).
For simplicity, assume that time is indivisible, so that individuals must spe-
cialize in their use of time; i.e., n = 0 (nonemployment) or n = 1 (employment).
Then the utility payoff from employment is given by V (1) = ln(w + a) and the
2 Implicit in this budget constraint is the assumption that individuals cannot save or borrow
and that there are no insurance markets.

utility payoff from nonemployment is V (0) = ln(a)+v. The optimal employment

decision is therefore given by:
½
∗ 1 if V (1) ≥ V (0);
n =
0 if V (1) < V (0).
Figure 7.2 plots the V (1) and V (0) as a function of the wage w (for a given a
and v).
FIGURE 7.2
Work versus Leisure
Utility
Payoff
V(1) = ln(w+a)
V(0) = ln(a) + v
ln(a)
0 wR w
Leisure Work
(n* = 0) (n* = 1)
Figure 7.2 reveals a common sense result: individuals whose skills command
a high price in the labor market are more likely to be working (holding all
other factors the same). In particular, individuals with w < wR will choose
leisure, while those with w ≥ wR will choose work. (Technically, those with
w = wR are just indifferent between working or not, but we can assume that
when indifferent, individuals choose work).
The wage wR is called the ‘reservation wage.’ The reservation wage is deter-
mined by the intersection of the functions V (1) and V (0) in Figure 7.2, so that
wR solves the equation:
ln(wR + a) = ln(a) + v. (7.4)
We can solve3 equation (7.4) for wR ; i.e.,
wR = (ev − 1)a. (7.5)
3 Recallthe following properties of logarithms: ln(ex ) = x ln(e) = x (since ln e = 1); and
ln(xy) = ln(x) + ln(y).
7.2. TRANSITIONS INTO AND OUT OF EMPLOYMENT 151
Notice that the reservation wage is a function wR (a, v); i.e., it depends positively
on both a and v.
The reservation wage has a very important economic interpretation. In par-
ticular, it represents the price of labor for which an individual is just indifferent
between working or not. In other words, it is the minimum wage that would
induce an individual to work. As such, the reservation wage is a measure of an
individual’s ‘choosiness’ over different wage rates. That is, an individual with a
high reservation wage is someone who is very choosy, while someone with a low
reservation wage is not very choosy. What determines an individual’s degree of
choosiness over job opportunities? The reservation wage function in (7.5) tells
us that there are two primary factors that determine choosiness: (1) the level of
non-labor income (a); and (2) the value of time in alternative uses (v). Choosy
individuals are those with either high levels of wealth or those who attach great
value to non-market activities.
Notice that the individual’s labor supply function can also be expressed in
terms of their reservation wage; i.e.,
½
1 if w ≥ (ev − 1)a;
n∗ =
0 if w < (ev − 1)a.
Expressing the labor supply function in this way makes it clear that labor supply
tends to be increasing in w, but decreasing in both a and v (higher levels of a
and v make people more choosy and therefore less likely to work at any given
wage).
Our theory also tells us how each person’s economic welfare (maximum util-
ity level) depends on their endowment (w, a, v). In particular, an individual’s
welfare is given by W (w, a, v) = max {ln(w + a), ln(a) + v} ; i.e., the maximum
of either V (1) and V (0). In Figure 7.2, W is just the ‘upper envelope’ of the func-
tions V (1) and V (0). According to our theory, the welfare function is (weakly)
increasing in w, a and v. What this means is that it is impossible for an in-
crease in any of these parameters to make an individual worse off (and will, in
general, make them better off). An important implication of this result is that
there is no straightforward way of linking a person’s employment status with
their level of welfare. Likewise, we cannot generally make statements about
how two economies are performing relative to each other simply by looking at
employment levels.
• Exercise 7.1. Consider two economies A and B that are identical in

every respect except that the individuals in economy A have greater levels
of wealth (as measured by the parameter a). According to our theory,
which economy is likely to exhibit the higher level of employment? In
which economy are individuals likely to be better off? Explain.
Figure 7.3 plots the reservation wage function wR (a, v) in (w, a) space for
two types of individuals who differ in v (vH > vL ). From equation (7.5), note
that the slope of the reservation wage function is given by (ev − 1)a ≥ 0.
FIGURE 7.3
Reservation Wage Functions
wR(a,vH)
B A
wR(a,vL)
0 a
An individual with a particular endowment (w, a) is located at some point

in the space depicted in Figure 7.3. Imagine that individuals are located at
various points in this space. Then type vH individuals located in region B
will be employed, while those located in regions A and C will be nonemployed.
Likewise, type vL individuals located in regions A and B will be employed, while
those located in region C will be nonemployed.
• Exercise 7.2. Consider two individuals (Bob and Zu) who are located
precisely at the point A in Figure 7.3 (i.e., they both have identical labor
market opportunities and identical wealth levels). Bob has v = vL while
Zu has v = vH . Which of these two people will be employed and which
will have a higher level of utility? Explain.
According to our theory, the aggregate level of employment is determined

by how individuals are distributed across the space (w, a, v). To the extent
that this distribution remains constant over time, so will the aggregate level of
employment (there will be no net changes in employment over time). However,
to the extent that individuals experience changes in (w, a, v), the economy will,
in general, feature gross flows of individuals into and out of employment similar
to what is observed in Figure 7.1. For example, consider an individual with
v = vL who is initially located at point A in Figure 7.3. Suppose that this
individual experiences a decline in the demand for their skill, so that the market
price of their labor falls (the individual moves to point C). Then this individual
7.3. UNEMPLOYMENT 153
will (optimally) make a transition from employment to nonemployment (and

the person will be made worse off in this case, owing to the exogenous decline
in the market value of his labor).
• Exercise 7.3. Consider two economies that are identical in every way
except that in one economy all individuals have zero wealth (a = 0).
Which economy will the higher level of output and employment? Which
economy will feature a higher degree of labor market turnover? Which
economy would you rather live in? Explain.
7.3 Unemployment
None of the models we have studied so far can explain the phenomenon of
unemployment. Some people have the mistaken impression that an unemployed
person is someone who ‘wants’ to work at ‘the’ prevailing wage rate, but for
some reason cannot find a job. Such a definition is problematic for a number of
reasons. First, since individuals obviously differ in skills (among other traits),
it is very difficult to identify what ‘the’ prevailing wage might be for any given
individual. An individual may claim to be worth $20 an hour but may in fact
be worth only $10 an hour. What would it mean for such an individual to claim
that they cannot find a job (that pays $20 an hour)?
But more importantly, this is not the way unemployment is defined in labor
market surveys. A labor market survey first asks a person whether they are
working or not. If they are working (or have worked in the reference period
of the survey), they are labeled as employed. If they report that they are not
working, the survey then asks them what they did with their time by checking
the following boxes (item 57 in the Canadian Labor Force Survey):
• 57 IN THE PAST 4 WEEKS, WHAT HAS ... DONE TO FIND WORK?

(Mark all methods reported):
¤ NOTHING;
¤ PUBLIC employment AGENCY;
¤ PRIVATE employment AGENCY;
¤ UNION;
¤ FRIENDS or relatives;
¤ Placed or answered ADS;
¤ LOOKED at job ADS;
¤ OTHER, Specify in NOTES.
The Current Population Survey in the United States asks a similar set of
questions. In Canada, if a nonemployed person checks off ‘nothing,’ then they
are labeled nonparticipants (or not in the labor force). In the United States,
if a person checks either ‘nothing’ or ‘looked at job ads,’ they are labeled as
nonparticipants. If any other box is checked, then the person is labeled as
unemployed. Clearly, a person is considered to be unemployed if: (1) they
are nonemployed; and (2) if they are ‘actively’ searching for employment. In
Canada, simply ‘looking at job ads’ is considered to be ‘active’ job search, while
in the United States it is not.
Notice that the survey never actually asks anyone whether they are unem-
ployed or not. Similarly, the survey does not ask whether people ‘want’ to work
but were unable to find work. For that matter, the survey also does not ask
people whether they ‘want’ leisure but were unable to find leisure (arguably a
much more relevant problem for most people). Thus, among the group of non-
employed persons, the unemployed are distinguished from nonparticipants on
the basis of some notion of active job search. Figure 7.4 provides some data for
Canada over the sample period 1976—1991 (again, from Jones, 1993).
FIGURE 7.4
Average Labor Market Stocks and Monthly Flows
Canada 1976 - 1991 (Jones, 1993)
245,000
275,000
Nonparticipation
6,624,000
Employment
11,100,000
216,000
183,000
235,000 Unemployment
1,084,000
190,000
Figure 7.4 reveals a number of interesting facts. First, observe that over half
of all individuals who exit employment in any given month become nonpartici-
pants, rather than unemployed (i.e., the exit the labor force, which is defined to
be the sum of employment and unemployment). Second, note that over half of
all individuals who find employment in any given month were not unemployed
(i.e., they find work as nonparticipants). This latter fact casts some doubt on the
empirical relevance of the concept of unemployment (nonemployed persons who
actively search for work). On the other hand, note that the monthly probability
of becoming employed is much greater for the unemployed (235/1084) = 0.217
than for nonparticipants (245/6624) = 0.037. This fact lends support to the no-
tion that the unemployed are more intensively engaged in job search activities.
The models that we have studied to this point are ill-equipped to deal with
the issue of unemployment (at least, as the concept is defined by labor force sur-
veys). The reason for this is because there is no need for our model individuals
to engage in job search activities. In those models, including the one developed
in the previous section, everyone knows where to get the best value (highest
wage) for their labor. They may not be happy about the going wage for their
labor, but given this wage the choice is simply whether to allocate time in the
labor market or allocate time to some other activity (like home production or
leisure). In order to explain unemployment, we have to model a reason for why
people would willingly choose to allocate time to an activity like job search.
7.3.1 A Model of Unemployment

Why do people search for jobs? For that matter, why do people search for
anything (like mates)? It seems apparent that the key friction that generates
search behavior is imperfect information concerning the location of one’s ideal
job match (or mate). In the model developed above, everyone knows where the
location of their best job presides; this job pays w. The time allocation choice
therefore only entails the question of whether or not to exploit the job oppor-
tunity that pays w (or equivalently, whether to exploit the home opportunity
that ‘pays’ v).
In order to model job search, let me reformulate the model developed above
in the following ways. First, let us assume (in order to simplify matters) that
preferences are given by:
u(c, l) = c + vl.
Individuals have one unit of time that they can still allocate either to work or
leisure. But now, there is a third option for their time: job search. Job search
occurs at the beginning of the period. Assume that the job search activity
consumes a fraction 0 < θ < 1 of the available time endowment. At the end of
the job search process, an individual must then choose to allocate any remaining
time (1 − θ) to either work or leisure.
Let us assume then that individuals begin each period with a job opportu-
nity that pays w, but that generally speaking, individuals realize that better job
opportunities exist ‘out there somewhere.’ Locating these better job opportuni-
ties takes time and the outcome of the search process is uncertain (individuals
may or may not come across better job opportunities when they search). Of
course, feel free to substitute the word ’job’ with ’mate;’ in which case we have
an explanation for why some people choose to be single (at least temporarily)
and search for mates.
For simplicity, assume that in order to search, an individual must forever
abandon his/her current job opportunity w (there is no going back to your old
boyfriend if you dump him). Let w0 denote the wage that will be paid at the
new job opportunity. During the search process, this new job is ‘located’ with
probability (1 − π), where 0 < π < 1 denotes the probability of failure. Remem-
ber that in the event of failure, individuals are free to allocate the remainder of
their time θ to leisure.
We must now try to discern which people choose to work, search or leisure.
We proceed in the following way. Suppose, for the moment, that search is not
an option. Then the reservation wage for individuals is given by wR = v (i.e.,
this is the wage that equates the utility payoff of work and leisure: wR + a =
a + v). Label those individuals who prefer work to leisure as type A individuals.
Likewise, label those individuals who prefer leisure to work as type B individuals.
We know that type A individuals prefer work to leisure. But if they are
now presented with a search option, which of these individuals prefer work to
search? The payoff to work is given by w. The (expected) payoff to search is
given by (1 − θ)[(1 − π)w0 + πv]. We can identify a reservation wage wR S
that
identifies the type A individual who is just indifferent between work and search;
this reservation wage is given by:
S
wR = (1 − θ)[(1 − π)w0 + πv]. (7.6)
S
Thus, any type A individual with w < wR will prefer search over work. This
reservation wage is depicted in Figure 7.5 in (w, v) space.
Let us now consider type B individuals. We know that these individuals
prefer leisure to work. But now that they have a search option, which of these
individuals will prefer search to leisure? The payoff to leisure is given by v.
S
The (expected) payoff to search is given by wR . Consequently, we can identify a
reservation ‘leisure value’ vR that just equates the payoff to leisure and search;
i.e.,
vR = (1 − θ)[(1 − π)w0 + πvR ].
We can solve the expression above for vR as follows:
∙ ¸
(1 − θ)(1 − π)
vR = w0 , (7.7)
1 − (1 − θ)π
and is plotted in Figure 7.5. Here, any type B individual with v < vR will prefer
search to leisure.
FIGURE 7.5
Work, Search and Leisure
w
wR = v
Work
w’
w R = (1 - q)[(1-p)w’ + pv]
S
Leisure
Search
0 vR v
Figure 7.5 reveals the following. The individuals who are most likely to
search are those who are presently poorly endowed in terms of both their present
job opportunity and home opportunity (i.e., low values of w and v). For these
individuals, allocating time to search is not very expensive (in terms of op-
portunity cost). The individuals who are most likely to work are those who
currently have a good job opportunity (w) and a comparative advantage in
working (w is high relative to v). The individuals who are most likely to choose
leisure (nonparticipants) are those who have a good home opportunity (v) and
a comparative advantage in leisure (v is high relative to w).
The model developed above here capable of generating labor market flows
between employment, unemployment, and nonparticipation. These flows are
triggered by changes in individual circumstances (i.e., changes in w and v). At
any point in time, some individuals have sufficiently poor market and nonmarket
opportunities that allocating time to search activity makes sense. Note that
not everyone who searches would be picked up by the Labour Force Survey as
being unemployed. In the model, the individuals who would be classified as
unemployed are those who search and are unsuccessful.
Finally, we know that individual welfare is generally increasing in both w
and v. Since those people who choose to search are those with very low w and
v, we can conclude that the unemployed are generally among the least well-off
in society. However, it is important to keep in mind that these people are less
well-off not because they are unemployed but because they are endowed with
low w and v. In particular, the concept of ‘involuntary unemployment’ makes no
sense (since people obviously have a choice whether to search or not). On the
other hand, it may make sense to think of some people as being involuntarily
endowed with poor skills or poor opportunities in the home sector. Since the
choice to search is voluntary, it follows that some level of unemployment (single
people) is optimal. For example, a government could in principle eliminate
unemployment by forcing people to work (a policy adopted in some totalitarian
regimes). While measured unemployment would fall to zero, one would be hard
pressed to argue that economic welfare must therefore be higher.
• Exercise 7.4. Using Figure 7.5, locate two individuals A and B such that
A chooses to work while B chooses to search, but where B is better off
than A (in terms of expected utility). Explain.
7.3.2 Government Policy
If individuals are risk-averse and if they are exposed to uncertainty in how

their economic circumstances evolve over time (i.e., random changes in w, a and
v), then they will want to insure themselves against such risk. Unfortunately,
markets that would allow individuals to insure themselves against changes in
the value of their human capital (i.e., changes in either w or v), either do not
exist or function poorly. The reason for why this is so is a matter of debate. One
view holds that because the true value of human capital is known only to the
individual (i.e., it is private information), individuals may have the incentive
to lie about the true value of their human capital just to collect insurance.
For example, if a person becomes unemployed, it is not clear whether he is
unemployed for ‘legitimate’ reasons (i.e., a true drop in w), or whether he is
simply choosing not to work and simply reporting a drop w. Since w is private
information, the insurance company has no way of knowing the truth and hence
no way of providing an insurance policy that pays for itself.4
In such an environment, there may be a role for government provided insur-
ance. Although the government must presumably cope with the same informa-
tion frictions that afflict private insurance markets, the government does have
one advantage over private firms. In particular, the government has the power
of coercion so that it can make participation mandatory and collect ‘fees’ by
way of taxes.5 By operating a well-designed insurance scheme, the government
may be able to improve economic welfare; see Andolfatto and Gomme (1996).
4 Another view holds that the source of the friction is a government policy that guarantees
the inalienability of human capital, thereby preventing insurance companies from garnisheeing
the returns to human capital; i.e., see Andolfatto (2002).
5 While governments make it difficult for private firms to garnishee human capital, the
government itself does not restrict itself in this manner; see the previous footnote.
7.4. SUMMARY 159
7.4 Summary
Aggregate fluctuations in the aggregate per capita labor input are generally
not very large. However, this apparent stability at the aggregate level masks
a considerable degree of volatility that occurs at the individual level. Modern
labor markets are characterized by large gross flows of workers into and out
of employment, as well as large gross flows into and out of other labor market
states, like unemployment and nonparticipation. These large gross flows suggest
that if policy is to be desired at all, it should likely be formulated in terms of
redistributive policies (like unemployment insurance and welfare), rather than
aggregate ‘stabilization’ policies (unless one takes the view that business cycles
are caused by ‘animal spirits’).
The notion of ‘unemployment’ is a relatively modern concept, evidently
emerging sometime during the Industrial Revolution (c. 1800). Unemploy-
ment is sometimes viewed as the existence ‘jobless’ workers or ‘individuals who
want work.’ Unemployment rate statistics, on the other hand, define the un-
employed at those individuals who are not working by actively searching for
work. The distinction is important because nonparticipants are also technically
‘jobless.’ And the concept of ‘wanting work’ does not make sense since work
is not a scarce commodity. What is scarce are relevant skills (which largely
determine the market price of one’s labor). To the extent that active job search
constitutes a productive investment activity, the notion that measured unem-
ployment represents ‘wasted’ or ‘idle’ resources (as is sometimes claimed) may
not be appropriate.
Judgements about the economic welfare of individuals or economies made on
the basis of labor market statistics like employment or unemployment must be
made with care. Economic well-being is better measured by the level of broad-
based consumption. The level of consumption attainable by individuals depends
on a number of individual characteristics, including skill, age, heath, work ethic
and wealth. The overall level of productivity (technology) and government
policies (taxes, trade restrictions, etc.), also have a direct bearing on individual
well-being. The choices that individuals make in the labor market are driven
primarily by their individual characteristics. Changes in these characteristics
may trigger labor market responses that do not vary in any systematic way with
economic welfare.
The individual characteristics that lead individuals to be unemployed are
typically such that the unemployed constitute some of the least fortunate mem-
bers of a society. However, one should keep in mind that most societies are also
made up of individuals who may be labelled the ‘working poor.’ Many nonpar-
ticipants are also not particularly well off. By narrowly focussing policies to help
the unemployed, one would be ignoring the plight of an even larger number of
individuals in need. To the extent that private insurance markets do not work
perfectly well, there may be a role for a government ‘consumption insurance’
policy to help those in need (be they unemployed, employed or nonparticipants).
7.5 Problems
1. Consider the utility function (7.3). The M RS for these preferences is given
by M RS = vc. Suppose that individuals are free to choose any 0 ≤ n ≤ 1.
Assume that v© ≥ 1. Show ª that an individual’s employment choice is given
by n∗ = max w−va vw , 0 . Find an expression for this person’s reservation
wage. Consider two individuals that differ in a (e.g., aH > aL ). Assume
that vaL < w < vaH . Depict the choices that these people make using an
indifference curve and budget line drawn in (c, l) space.
2. Many economies have instituted minimum wage laws; i.e., laws that pre-
vent individuals from working at jobs that pay less than some mandated
wage wM . Using the theory associated with Figures 7.2 and 7.3, explain
the economic and welfare consequences of such a law. Does a minimum
wage lead to unemployment in this model? Explain.
3. Recent technological advances in information technology (IT), for exam-
ple, Ebay and Workopolis.com, have led to an increase in the efficiency
of matching technologies. In the context of the model developed in this
chapter, one might capture such technological advances by supposing that
pA (v) > pB (v) and qA (v) > qB (v). According to our theory, how is such a
technological advancement likely to affect the equilibrium level of vacan-
cies and the natural rate of unemployment?
4. Figure 7.7 (see Appendix 7.A) was drawn under the assumption that 0 <
(1−s−p) < 1. However, it is also possible that −1 < (1−s−p) < 0. Redraw
Figure 7.7 under this latter assumption and show how, for any given initial
level of unemployment, the equilibrium dynamic path of unemployment
‘oscillates’ as it approaches the natural rate of unemployment.
7.6 References
1. Andolfatto, David (2002). “A Theory of Inalienable Property Rights,”
Journal of Political Economy, 110(2): 382-393.
2. Andolfatto, David and Paul A. Gomme (1996). “Unemployment Insurance
and Labor Market Activity in Canada, Carnegie-Rochester Conference
Series on Public Policy, 44: 47—82.
3. Jones, Stephen R. (1993). “Cyclical and Seasonal Properties of Canadian
Gross Flows of Labour,” Canadian Public Policy, 19(1): 1—17.
4. Pissarides, Christopher A. (1985). “Short-Run Equilibrium Dynamics of
Unemployment, Vacancies and Real Wages, American Economic Review,
75(4): 676—690.
7.A. A DYNAMIC MODEL OF UNEMPLOYMENT 161
7.A A Dynamic Model of Unemployment

In this appendix, I describe a simplified version of a popular model introduced
by Pissarides (1985). Imagine a world with a fixed number of individuals who
either work if they have a job or search if they do not (i.e., assume that v = 0).
The economy is also populated by firms that either produce output (if they have
a worker) or recruit workers (i.e., are vacant) if they do not. Each firm requires
only one worker and a firm-worker pair produce a level of output equal to y.
Firm-worker pairs negotiate a wage payment that divides the output y be-
tween them. Let π = θy denote the profit accruing to the firm (so that (1−θ)y is
the wage paid to the worker), where 0 < θ < 1 is now a parameter that indexes
the bargaining power of the firm. After producing output in the current period,
the firm-worker match survives into the next period with probability (1 − s),
where 0 < s < 1 is an exogenous probability of separation (the probability that
some shock occurs that results in the firm shutting down). If the firm-worker
pair survive into the next period, they produce output (and split it) as before.
If the firm-worker match breaks down, then the firm becomes vacant and the
worker becomes unemployed. If we let r denote the real (net) rate of interest,
then the capital value (i.e., the present value of the expected stream of profits)
is given by:
θy
J= . (7.8)
r+s
• Exercise 7.5. Explain (i.e., do not simply describe) how the value of a
firm depends on the parameters θ, y and s.
Since there is no centralized labor market, vacant firms and unemployed

workers must seek each other out in a ‘matching market.’ A vacant firm must
pay the cost κ to enter this market, but unemployed workers are let in for free
(feel free to interpret vacant firms as ‘single men,’ unemployed workers as ‘single
women,’ and the matching market as a ‘nightclub’). Once inside the ‘nightclub,’
the matching technology works as follows. Let x denote the number of vacant
firms (that choose to pay the entrance fee). Then a vacant firm matches with
an unemployed worker with probability q(x). Assume that q is a decreasing
function of x, which implies that a greater number of vacancies increases com-
petition among searching firms and so reduces the chances of any given vacancy
from ‘making contact’ with an unemployed worker. An unemployed worker,
on the other hand, finds a suitable vacancy with probability p(x), where p is
an increasing function of x (the greater the number of men, the better are the
chances for the ladies).
If a vacant firm meets an unemployed worker, then they begin to produce
beautiful output together. Thus, from the perspective of the vacant firm, the
expected gain from paying the recruiting cost κ is given by q(x)J. If q(x)J > κ,
then it would be worthwhile for more unmatched firms to incur the cost κ, which
would then lead to an increase in the number of vacancies x. But as x increases,
the probability of a successful match falls. Imagine that x increases to the point
x∗ such that an unmatched firm is just indifferent between paying the entrance
cost κ and not; i.e.,
q(x∗ )J = κ. (7.9)
The condition above is depicted graphically in Figure 7.6.
FIGURE 7.6
Determination of Vacancies
Benefit
Cost
q(x)J
0 x* x
• Exercise 7.6. Using conditions (7.8) and (7.9), show that an exogenous
increase in productivity (y) leads to an increase in recruiting intensity
(vacancies). Depict the change in a diagram similar to Figure 7.6. Explain
the economic intuition behind this result.
The final thing to show is what this theory implies for the evolution of the
level of unemployment over time. The level of unemployment at any given
point in time t is given by ut . If we let L denote the labor force, then the level
of employment is given by L − ut . Since L is a constant, we are free to set L
to any number; e.g., L = 1 (so that ut now represents the unemployment rate).
Over time, the unemployment rate must evolve according to:
Future Unemployment = Current Unemployment + Job Destruction - Job Creation;
or,
ut+1 = ut + s(1 − ut ) − p(x∗ )ut ; (7.10)
= s + (1 − s − p(x∗ ))ut .
7.A. A DYNAMIC MODEL OF UNEMPLOYMENT 163
Equation (7.10) is depicted in Figure 7.7 (assuming that 0 < p + s < 1).
FIGURE 7.7
Equilibrium Unemployment
Rate Dynamics and Steady State
ut+1
ut+1 = ut
ut+1 = s + (1 - s - p(x*))ut
u*
0 u* ut
• Exercise 7.7. Use Figure 7.5 to show that for any given initial unem-
ployment rate u0 , that the equilibrium unemployment rate converges to a
steady-state unemployment rate u∗ .
The unemployment rate u∗ in Figure 7.7 is called a ‘steady-state’ unemploy-

ment rate because once this point is reached, the economy will stay there forever
(assuming that nothing else changes). Sometimes, u∗ is called the natural rate
of unemployment (NRU). We can use equation (7.10) to solve for the NRU; i.e.,
setting ut+1 = ut = u∗ , we can calculate:
s
u∗ = . (7.11)
s + p(x∗ )
• Exercise 7.8. In many countries, the government levies a payroll tax on

firms and uses the proceeds to pay unemployed workers unemployment
benefits. Using the theory developed above, explain what effect such a
payroll tax is likely to have on the natural rate of unemployment (hint: a
payroll tax will reduce J).
• Exercise 7.9. Data from many countries reveals that there is a negative
relationship between unemployment and vacancies; see Figure 7.8. This
negative relationship is referred to as the ‘Beveridge Curve.’ Is the theory
developed above consistent with the observed Beveridge curve relationship

in the data?
Figure 7.8
Canadian Unemployment and
Vacancy Rates
1966 - 1988
12
11
10
9
Percent
3
66 68 70 72 74 76 78 80 82 84 86 88
Help Wanted Index (Vacancies) Unemployment Rate

Part II
Macroeconomic Theory:
Money
165
Chapter 8
Money, Interest, and Prices
8.1 Introduction
None of the theory developed to this point has been concerned with explaining
the behavior of nominal variables, like the nominal GDP, the nominal wage,
and the price-level. This is because the theory developed above abstracts from
any concept of money. Since nominal variables constitute values measured in
units of money, the absence of money in any model necessarily prevents one
from addressing nominal phenomena.
To many people, it seems surprising to think that one can understand the
behavior of an economy without any reference to money. Money appears to be
prevalent in our everyday lives and in economic discussions. We go to work for
money, we buy goods with money, we go the bank to borrow money, we hear of
vast quantities of money being exchanged in financial markets, we see the value
of our money rise and fall relative to other monies, we see the government take
our money, and we envy people with gobs of money. Money, money, money.
Surely any theory of the way a macroeconomy functions should have money
playing a prominent role?
Very few macroeconomists would attempt to argue that money and monetary
phenomena are unimportant and undeserving of any attention. The contentious
issue among macroeconomists concerns the relative importance of money vis-
à-vis other factors in determining real (as opposed to nominal) economic out-
comes. The models studied in earlier chapters implicitly took the view that
money plays a relatively minor role in determining real outcomes. Since people
presumably care about real outcomes, money was ignored. Not all macroecono-
mists share this view. In the chapters that follow, we will explore their reasons
for believing this to be the case.
167
168 CHAPTER 8. MONEY, INTEREST, AND PRICES
8.2 What is Money?

When I ask students this question, they often pull out a $5 bill and say ‘this is
money.’ I tell them that is not a very good answer. To demonstrate my point,
I pull out a cigarette and say ‘no, this is money.’ Usually, they don’t get the
point. The point is that anyone can claim that something is money. But what is
it about such objects that makes us call them ‘money?’ What is the definition
of money?
Unfortunately, there is no commonly accepted general definition of money.
But for our purposes, the following definition appears to be just as good as any
other.
Definition: Money is an object that circulates widely as a means of payment.
This is not an entirely satisfactory definition, since it does not specify ex-
actly what ‘circulate widely’ means. Nevertheless, let’s work with it anyway.
Certainly, the $5 bill seems to fit this definition; hence, it constitutes an example
of money. But then again, there are alleged cases where cigarettes appear to fit
this definition too (e.g., in WWII prisoner-of-war camps). In fact, one could fill
a small book describing all the objects that appear to have served as a means
of payment throughout the course of human history (e.g., gold, silver, playing
cards, shells, stones, animals, etc.)
History is history, one might argue. In modern economies, money is made up
of these little paper objects—like this $5 bill. By the way, have you ever looked
closely at a (Canadian) $5 bill? It is blue-gold in color featuring a picture of
some old guy with a big nose.1 People actually work hard (sacrifice leisure)
to acquire these ugly things? If this is the case, what prevents anyone from
printing up similar notes and using them to purchase goods and services? Well,
for one thing, such an activity is illegal. If you stared at your $5 bill closely,
you may have noticed that it is issued by the Bank of Canada and assures us
that ‘this note is legal tender.’ The Bank of Canada is essentially a branch of
the federal government. Basically, the government is warning us here that the
only type of paper that can legally be used in exchanges is its own paper (and
not any other paper that you may be thinking of manufacturing).2
But despite the government’s monopoly control of the paper money supply,
you may be surprised to learn that most of the money supply in any well-
developed economy does not take the form of small-denomination government-
issued paper notes. Most of economy’s money supply consists of a particular
form of debt instrument issued predominantly by chartered banks in the private
1 Sir Wilfrid Laurier, Prime Minister of Canada (1896—1911).
2 The question of why governments have legislated themselves such a monopoly is an inter-
esting issue. As usual, there are two (if not more) opposing views. The first view asserts that
paper money constitutes a ‘natural monopoly,’ best handled by a benevolent government. The
second view asserts that the government is motivated primarily by the power its monopoly
confers in generating revenue.
8.3. PRIVATE MONEY 169
sector. These debt instruments are called checkable deposits or demand deposit
liabilities.3 This form of credit does not exist in paper form; i.e., it exists as
an electronic book-entry. Your checking account (or checkable saving account)
is an example of this type of money. It is called a demand deposit because
you have the right to redeem your book-entry money for government cash on
demand (as when you visit an ATM to make a cash withdrawal).4
Clearly, cash is not the only way in which one may pay for goods and ser-
vices. Many payments are made using checks or debit cards. When you pay
for something using a check, the check instructs the banking system to debit
your account by an amount equal to the value of the purchase and credit the
merchant’s account by the same amount. A debit card transaction does the
same thing. No cash need ever change hands in such transactions. Neverthe-
less, book-entry credits ‘circulate’ from account to account (instead of hand
to hand) and therefore constitute a form of money. Whether money exists in
paper or electronic form, its common purpose is to serve as a record-keeping
device (i.e., recording the transfer of debits and credits across individuals as
they exchange goods and services).
To the extent that the private sector is able to perform such record-keeping
services in a relatively efficient manner, one need not be concerned with mone-
tary phenomena when trying to understand the behavior of real economic vari-
ables. In a well-function monetary/financial system, the private sector can be
expected to create all the money it needs to facilitate economically worthwhile
exchanges. The amount of money may fluctuate over time, but it will do so
only in response to changes in economic fundamentals. This is the implicit
assumption adopted in the first part of the text.
8.3 Private Money
8.3.1 The Neoclassical Model

Let us reconsider the neoclassical model developed in Chapter 2. In particular,
refer to Figure 2.4. In that model, we thought of trade between workers and
firms as occurring in two stages. In the first stage, workers supply labor to firms
in exchange for claims against the output produced by the business sector. We
can think of these claims as ‘money;’ this type of money takes the form of
privately-issued liabilities redeemable in output (e.g., gas coupons).
Assume that the business sector creates Mt units of this money at the be-
ginning of date t, where these units are called ‘dollars.’ This money is used to
purchase employment services n∗t . At this stage, Mt represents nominal GDP
3 in Canada, for the year 1999, currency in circulation totalled approximately $32 billion
(about $1,000 per person), while demand deposits totalled approximately $208 billion.
4 Historically, chartered banks were allowed to issue small-denomination paper money re-
deemable on demand for specie (gold or silver coins).

(income-based measure). The nominal wage rate is given by Wt = Mt /n∗t (the

dollars earned per unit of labor).
In the second stage of trading, the household takes its labor income Mt =
Wt n∗t and uses it to purchase the output produced in the business sector, yt∗ =
zt n∗t . At this stage, Mt represents the nominal GDP (expenditure-based). The
price-level is given by Pt = Mt /yt∗ (the dollars spent per unit of output).
In this economy, the real wage is given by:
Wt Mt zt n∗t
wt∗ = = ∗ = zt .
Pt nt Mt
Notice that this is exactly the same real wage that we derived in Chapter 2,
where we ignored money. In this economy, people exchange labor for money
and money for output. But in an obvious sense, money is just a ‘veil’ that hides
the true nature of the exchange (i.e., the exchange of labor for output).
The other thing we might note from this example is that the economy’s nom-
inal variables appear to be indeterminate. In other words, we cannot point to
any fundamental market forces that might determine (Wt , Pt , Mt ). In particu-
lar, the business sector can create any amount of money it wants. Having done
so, nominal wages and prices simply adjust to the quantity of money in a way
that leaves real variables unchanged. Alternatively, we might imagine that the
price-level is determined exogenously (say, by social convention). In this case,
the nominal wage and the supply of money simply adjusts to leave real vari-
ables unchanged. Money and monetary phenomena are simply not important
(or interesting) in a neoclassical model.
8.3.2 Wicksell’s Triangle: Is Evil the Root of All Money?

Money can be given a more serious role in models that explicitly highlight the
‘frictions’ that may make money important for facilitating exchange. One such
friction is what economists have labelled a ‘lack of double coincidence of wants,’
or ‘lack of double coincidence’ (LDC) for short. The basic idea of LDC is
as follows. Consider an economy consisting of three people, named A, B and
C. Each person has a time-dated endowment yj , j = 1, 2, 3 and a particular
preference structure for time-dated consumption. In particular, A has y3 but
wants y1 . B has y1 but wants y2 . And C has y2 but wants y3 . Notice that if we
pair any two individuals with each other, they will not trade. This is what is
meant by a LDC.
But why should we think of these individuals as being paired off? Why
don’t they all just get together at some central market place (the neoclassical
assumption) and swap claims to their output with each other? In particular,
imagine that everyone promises to deliver to each other the good that they want
to consume? If people can be trusted to make good on their promises, then
events will unfold as follows. A consumes y1 in the first period, B consumes
8.3. PRIVATE MONEY 171
y2 in the second period, and C consumes y3 in the third period. Everyone gets
what they want (without using money).
As the example above demonstrates, the existence of a LDC is not sufficient
to explain the use of money in an economy. We need to introduce some other
‘friction.’ Kiyotaki and Moore (2000) suggest the following. Imagine that B and
C are ‘untrustworthy;’ i.e., they cannot keep any promises they make. Kiyotaki
and Moore describe this lack of commitment on the part of people as an ‘evil’
that is present in the world. However, imagine that not everyone is ‘evil’ in this
sense. In particular, assume that A is able to keep his promises (and that this
is generally known). Clearly, getting together and exchanging promises is not
going to work here.
But what will work is the following. Imagine that A issues a debt instrument
that represents a claim against y3 . By assumption, A will honor any such claim.
In period one, A and B meet, where B gives up his good (y1 ) in exchange
for A’s debt-instrument. This may sound like a strange thing to do from B’s
perspective; after all, B does not value y3 . Nevertheless, it is rational for B
to sacrifice his endowment for such a claim. In particular, while B does not
value y3 , he knows that there is somebody out there that does and that this
person may have something that B does value. This other person is C. In period
two, B and C meet, where C gives up his good (y2 ) in exchange for A’s debt
instrument. It is rational for C to sacrifice his endowment in this way since C
knows that he can redeem the debt-instrument for y3 (which he values). In this
exchange pattern, we can clearly identify a monetary instrument (an IOU issued
by A). Money is necessary to facilitate exchange in this economy because of a
LDC and a general lack of commitment.5 The trading pattern just described is
depicted in Figure 8.1.
5 Hence, Kiyotaki and Moore are led to proclaim that ‘evil is the root of all money.’
Figure 8.1
Wicksell’s Triangle
IOU y3
Have: y3 Have: y2
A C
Want: c1 Want: c3
IOU y3 IOU y3
Have: y1
B
Want: c2
One way to interpret this economy is that A represents a ‘bank’ (a trusted

financial institution), while B and C individuals represent various anonymous
members of the population.6 In the first period, B makes a ‘deposit’ (consisting
of y1 ) and A issues a liability (in exchange for the deposit) that is collateralized
by the bank’s ‘capital’ (a claim to future output, y3 ). This collateralized private
debt instrument then circulates in a series of exchanges, before it is ultimately
redeemed at the bank. If one is willing to interpret y3 as ‘gold,’ then this
economy resembles the way money was created in many historical episodes (e.g.,
the so-called free-banking era in the United States, 1836—1863).
Note that in this model, money plays an important role in facilitating trans-
actions (without money, there would be no trade). Furthermore, observe that
the trading patterns that do occur coincide with what would have occurred in
a neoclassical model with well-functioning markets (i.e., where all agents can
commit to their promises). Here then, is another example of a general point
that I made already: To the extent that money/financial markets work well, we
can ignore money if we are only interested in understanding the behavior of real
allocations.
6 If individuals view themselves as anonymous, then they will not be willing to accept each
other’s promises.
8.4. THE QUANTITY THEORY OF MONEY 173
8.3.3 Government Money

Traditionally, most macroeconomic models that include money view things from
an opposite extreme; i.e., under the assumption that the economy’s money
supply is created (or at least controlled) by the government (instead of the
private sector). In the context of the models described above, this change in
perspective turns out to be innocuous.
Consider, for example, the neoclassical labor market model. Here we can
imagine that the government creates Mt dollars of money and either lends or
gives it to the business sector. The business sector then uses this money to
purchase labor and households subsequently use their money income to purchase
output. Since Mt is viewed as exogenous, the equilibrium price-level is given
by:
Mt
Pt∗ = ∗ ; (8.1)
yt
with the nominal wage being determined by Wt∗ = zt /Pt∗ .
Likewise, in the context of the Wicksellian model, imagine that the govern-
ment creates M units of money and then lends it to the A individual. The
sequence of exchanges may now proceed on a sequence of spot markets where
goods trade for government money. The equilibrium price-level at each date is
given by Pt∗ = M/yt .
The only ‘benefit’ of viewing things in this manner is that equilibrium nom-
inal variables are now determinate (by assuming that Mt is exogenous). In
particular, the price-level (and inflation) is now under control of government
policy. Whether this view holds in reality, however, depends on the extent to
which government policy may actually control the economy’s money supply. As
I mentioned earlier, in reality, most of an economy’s supply (i.e., that part that
does not constitute paper) is created by the private sector.
8.4 The Quantity Theory of Money

One of the oldest theories in macroeconomics is the so-called Quantity Theory
of Money (QTM).7 The QTM is perhaps an inaccurate name for the theory,
since it does not constitute a theory of money. In fact, the QTM constitutes a
theory of the price-level (and inflation), which happens to emphasize the role
played in such matters by an exogenously determined quantity of money.8
The QTM begins with the assumption that individuals demand money.9 In
7 See, for example, Laidler (1985), for an extensive discussion of the QTM.
8 As such, the QTM may be more accurately labelled as ‘The Quantity of Money Theory
of the Price-level.’
9 Hence, the QTM is not a theory of money since it does not specify the conditions under
which people value money. Note that this is in contrast to the Wicksellian model studied
earlier.
its simplest version, the theory assumes that the demand for money is propor-
tional to the volume of trade, say, as measured by the nominal GDP; i.e.,
MtD = κPt yt , (8.2)
where κ > 0 is an exogenous parameter and yt is viewed as being determined

by a neoclassical labor market (as in Chapter 2).
The QTM then asserts that the supply of money fully controlled by govern-
ment policy; i.e.,
MtS = Mt . (8.3)
The equilibrium price-level is then viewed as being determined by a ‘money
market clearing condition;’ i.e., combining equations (8.2) and 8.3):
Mt = κPt yt ;
which can be solved for:

Mt
Pt∗ = . (8.4)
κyt
Note the resemblance between (8.4) and (8.1).
Hence, the QTM predicts that the price-level is proportional to the stock of
money. In particular, for a given demand for real money balances (κyt ), and
exogenous increase in Mt will lead to an increase in the price-level. Intuitively,
if there is more money ‘chasing’ a given level of output, one would expect the
price of output (measured in units of money) to increase.
• Exercise 8.1. The price-level measures the value of output in units of

money. Alternatively, one could think of a value for money measured in
units of output. According to (8.4), what happens to the value of money
when Mt is increased? Explain.
Note that since the real GDP is determined independently of Mt , exogenous

changes in the money supply have no effect of on any real economic variables.
Monetary policy here can only influence nominal variables. Any model that
features this property is said to feature money neutrality.
Definition: Money is said to be neutral if exogenous changes in the supply of

money have no effect on real quantities and real prices.
If money is indeed neutral in reality, then there would be little point in

studying money or monetary policy. Most economists take the view that money
is neutral in the ‘long-run,’ but not necessarily in the ‘short-run.’ The evidence
for short-run neutrality, however, does not appear to hold universally; e.g., see
Appendix 8.A.
8.4. THE QUANTITY THEORY OF MONEY 175
With a little more work, the QTM can be transformed into a theory of
inflation. Inflation is defined as the rate of growth of the price-level; i.e.,
Pt − Pt−1
πt ≡ .
Pt−1
Note that πt may be either positive or negative. A negative inflation rate is
called deflation. Note that we can alternatively define the gross rate of inflation
as Πt ≡ Pt /Pt−1 = (1 + πt )
• Exercise 8.2. What is happening to the value of money over time when
an economy is experiencing an inflation/deflation?
Assume that the government expands the supply of money at some con-
stant rate μ, so that Mt = (1 + μ)Mt−1 . You can think of Mt−1 as being ‘old’
money and μMt−1 as representing ‘new’ money that injected into the economy
in some manner (the QTM does not specify any details concerning how this new
money is injected). Furthermore, assume that the ‘real’ economy grows at some
exogenous rate γ, so that yt = (1 + γ)yt−1. Now, from (8.4) one can derive:
Pt∗ Mt yt−1
∗ =
Pt−1 Mt−1 yt
(1 + μ)
Π∗ = .
(1 + γ)
Note that if μ and γ are ‘small’ numbers, then π∗ ≈ μ − γ.
Thus, the QTM predicts that the economy’s inflation rate depends positively
on the rate of growth of the money supply and negatively on the rate of growth
of the real economy (i.e., the rate of growth of the demand for real money
balances). Again, the intuition is simple. If the money supply grows faster than
the demand for real money balances, then the price of output will rise (the value
of money will fall) over time.
In this version of the QTM, the monetary policy parameter is given by
μ. Note that since the ‘real’ economy here (i.e., yt and γ) is viewed as being
determined independently of the growth rate of money, exogenous changes in μ
have no effect on any real variables. Any model that features this property is
said to feature money superneutrality.
Definition: Money is said to be superneutral if exogenous changes in the rate

of growth of the supply of money have no effect on real quantities and real
prices.
The evidence for superneutrality is mixed. Most economists take the view
that money is superneutral, at least, for low to moderate inflations/deflations.
On the other hand, historical episodes of extremely high inflations (hyperinfla-
tions) seem to suggest that money is not superneutral. When inflation is very
high, the value of money declines very rapidly, inducing people to take extra-
ordinary measures (involving real resource costs) to economize on their money
holdings. Over the period July-November 1923 in Germany, for example, the
price-level rose by 854,000,000,000%. According to some sources:
“Workmen are given their pay twice a day now—in the morning and
in the afternoon, with a recess of a half-hour each time so that they
can rush out and buy things—for if they waited a few hours the value
of their money would drop so far that their children would not get
half enough food to feel satisfied.”
Evidently, merchants eventually found that they had trouble marking up their
prices as fast enough.
“So they left the price marks as they were and posted (hourly) a
new multiplication factor. The actual price marked on the goods
had to be multiplied by this factor to determine the price which had
to be paid for the goods. Every hour the merchant would call up
the bank and receive the latest quotation upon the dollar. He would
then alter his multiplication factor to suit and would perhaps add a
bit in anticipation of the next quotation. Banks had whole batteries
of telephone boys who answered each call as follows: ‘100 milliarden,
bitte sehr, guten Tag.’ Which meant: ‘The present quotation on the
dollar is 100 billion marks, thank you, good day.”10
According to the QTM, episodes like the German hyperinflation are ‘caused’
by an overly expansionary monetary policy. High money growth rates imply high
inflation. The way to prevent inflation is keep the money supply expanding at
a moderate rate (approximately equal to the growth rate of the real economy).
Indeed, if one looks at a cross-section of countries, the correlation between
inflation and money growth appears to be very high. The same is true for time-
series observations within a country over ‘long’ periods of time (the correlation
is not as strong over ‘short’ intervals of time). This type of evidence is usually
interpreted as lending support for the QTM. On the other hand, Smith (1985)
documents one of several historical episodes in which rapid money supply growth
appears to have resulted in little, if any, inflation.
In any case, even if there is a strong positive correlation between inflation
and money growth, care must be taken in inferring a particular direction of
causality. The QTM asserts that inflation is ‘caused’ by monetary policy. One
way to think about this is that some exogenous event increases a government’s
demand for resources (e.g., the need to finance post WWI war reparations, in
the case of Germany) and the way it chooses to finance this need is by creating
new money.
1 0 These quotes were obtained from: http:// ingrimayne.saintjoe.edu/ econ/ Economic-
Catastrophe/ HyperInflation.html
8.5. THE NOMINAL INTEREST RATE 177
Alternatively, one might take the view that the direction of causality works in
reverse. There appears to be a hint of this in the previous quote which suggests
that merchants increased their product prices in anticipation of the future value
of money. One way in which this might happen is through a ‘wage-price spiral’
that is accommodated by the government. That is, instead of assuming that Mt
is chosen exogenously, imagine that the government prints an amount of money
that is demanded by the private sector. In the context of our simple neoclassical
labor market model, the amount of money printed (in the first stage) will depend
on the nominal wage; i.e., Mt∗ = Wt n∗t . Now, imagine that the nominal wage
is chosen in a way that targets the equilibrium real wage zt ; i.e., Wt = zt Pte ,
where Pte denotes the price-level that is expected to occur (in the second stage).
In this setup, the rate of money growth is determined by the expected rate of
inflation; i.e.,
Mt∗ Pte
∗ = e .
Mt−1 Pt−1
If these expectations are correct, then the actual inflation rate will correspond
to the expected inflation rate.
A wage-price spiral may be initiated then by an exogenous increase in in-
flation expectations. Higher expectations of inflation lead workers to negotiate
higher nominal wages (to maintain their real wages). The business sector re-
sponds by either creating or acquiring the necessary money to accommodate
these wage demands. The additional money created in this wage then generates
a higher inflation (confirming expectations).
An economist trained in the QTM is likely to accept these logical possibil-
ities. However, he or she would nevertheless maintain that inflation is ‘always
and everywhere a monetary phenomenon.’ In particular, while the German hy-
perinflation may have been ‘caused’ by the government’s revenue needs, an inde-
pendent monetary authority could have prevented the hyperinflation by refusing
to accommodate the demands of the fiscal authority. Likewise, a wage-price spi-
ral can be avoided by having a ‘strong’ monetary authority that is unwilling to
accommodate the private sector’s (expectations driven) demand for money.
8.5 The Nominal Interest Rate

In earlier chapters, we introduced the concept of a real interest rate as a relative
price of time-dated output and discussed how the equilibrium real interest rate
is determined in a neoclassical model; i.e., see Sections 4.5 and 6.5. In reality,
there are rarely any direct measures of the real interest rate. Most interest rates
that are quoted are nominal. The nominal interest rate is also a relative price;
it is the relative price of time-dated money.
To examine the link between the real and nominal interest rate, consider
the following two debt instruments. Imagine that the government issues two
types of bonds: a nominal bond (by far the most common) and a real bond
(considerably more rare). Assume that both types of bond instruments are
risk-free. A nominal bond constitutes a contract stipulated in nominal terms.
For example, if I purchase a nominal bond for Bt dollars at some date t, the
government promises to return Rtn Bt dollars (principal and interest) at some
future date t + 1. Here, Rtn denotes the (gross) nominal interest rate. The
nominal interest rate tells us that one dollar today is worth 1/Rtn dollars in the
future.
Similarly, a real bond constitutes a contract stipulated in real terms. For
example, if I purchase a real bond for bt units of output at some date t, the
government promises to return Rt bt units of output (principal and interest) at
some future date t + 1. Here, Rt denotes the (gross) real interest rate. The real
interest rate tells us that one unit of output today is worth 1/Rt units of output
in the future.
In practice, the contractual stipulations in a real bond are also specified in
units of money. In addition, however, the contract links the dollar repayment
amount to the future price-level; i.e., Pt+1 . In other words, the difference be-
tween a nominal bond and a real bond is that the latter is indexed to inflation.
Thus, if I give up Bt dollars today to purchase either a real or nominal
bond, I am in effect sacrificing Bt /Pt = bt units of output (which I could have
purchased and consumed). A nominal bond returns Rtn Bt dollars to me in the
future. The purchasing power of this future money is given by Rtn Bt /Pt+1 . A
real bond returns Rt bt units of output (purchasing power) to me in the future.
Now let us compare the real rates of return on each of these debt instruments.
The rate of return on an asset is defined as:
Return
ROR ≡ .
Cost
Hence, the real rate of return on a nominal bond is given by:
Rtn Bt /Pt+1 Rn
RORnominal b ond = = t.
Bt /Pt Πt
The real rate of return on a real bond is given by:
Rt bt
RORreal b ond = = Rt .
bt
Which of these two assets would you rather invest in? Recall that both debt
instruments are free of risk. If this is the case, you should prefer to invest in
the bond instrument that yields the higher real return (the nominal return is
irrelevant). In fact, for both of these bonds to be willing held in the wealth
portfolios of individuals, it must be the case that the two bonds earn the same
real return; i.e.,
Rn
Rt = t . (8.5)
Πt
8.5. THE NOMINAL INTEREST RATE 179
This condition is constitutes a simple application of a no-arbitrage-condition.

If this condition did not hold, then bond traders would be able to make huge
amounts of profit, for example, by shorting the lower return instrument and
using the proceeds to purchase long positions in the higher return instrument.
Such arbitrage opportunities are not likely to last very long in a competitive
financial market. The sell pressure on the low return bond will reduce its price,
thereby increasing its yield. Likewise, the buy pressure on the high return
bond will lower its price, thereby increasing its yield. In equilibrium, arbitrage
opportunities like this will cease to exist; i.e., the returns must adjust to satisfy
(8.5).
8.5.1 The Fisher Equation
Condition (8.5) can be rewritten as:
Rtn = Rt Πt ;
or, in terms of net rates:
rtn ≈ rt + πt .
Written in this way, this condition is often referred to as the Fisher equation.
The Fisher equation constitutes a theory of the nominal interest rate. It claims
that the (net) nominal interest rate should be approximately equal to the (net)
real interest rate plus the (net) rate of inflation. The intuition is simple. Given
that there are other assets (e.g., capital or indexed bonds) in the economy that
yield a real return rt , the nominal return on a nominal bond had better return
enough future dollars to compensate for the expected loss in the purchasing
power of money (inflation). Only if the nominal interest rate is high enough
to compensate for (expected) inflation will individuals be willing to hold an
non-indexed nominal bond.
Evaluating the empirical legitimacy of the Fisher equation is not a straight-
forward exercise. For one thing, properly stated, the theory suggests that the
nominal interest rate should be a function of the expected real interest rate and
the expected rate of inflation. Direct measures of such expectations can be hard
to come by (especially of the former). Often what is done is to assume that
the expected inflation rate more or less tracks the actual inflation rate, at least,
over long periods of time. According to the Livingston Survey of inflation ex-
pectations, this is probably not a bad assumption, although there does appear
to be a tendency for expectations to lag actual movements in inflation; i.e., see
Figure 8.2.
FIGURE 8.2
Inflation and Expected Inflation
United States 1970.1 - 2003.3
12
10
Percent per Annum
8
0
1970 1975 1980 1985 1990 1995 2000
Inflation Expected Inflation
Consider next the time-series behavior of the nominal interest rate and in-
flation in the United States:
8.6. A RATE OF RETURN DOMINANCE PUZZLE 181
FIGURE 8.3
Inflation and the Nominal Interest Rate
16
12
Percent per Annum
0
55 60 65 70 75 80 85 90 95 00
Inflation Nominal Interest Rate
According to Figure 8.3, the long-term movements in the nominal interest

rate do appear to follow at least the trend movements in inflation (and hence,
inflation expectations) in a manner consistent with the Fisher equation. Note,
however, that the correlation is not perfect, especially for short-run movements.
This latter observation is not necessarily inconsistent with the Fisher equation
since these short-run movements could be the result of movements in the (short-
run) real interest rate. In fact, because the logic of the Fisher equation is viewed
as so compelling, economists typically assume that it is true and then use the
equation to derive a measure of the real interest rate!
8.6 A Rate of Return Dominance Puzzle

Let us reconsider the no-arbitrage principle (NAC) discussed earlier in reference
to the Fisher equation. This principle can be formally stated as follows:
No-Arbitrage Principle: Any two assets sharing identical risk characteris-

tics must yield the same expected return if they are both to be held willingly
in the wealth portfolios of individuals.
Stated another way, if one of these two assets does yield a lower rate of return,
then it will be driven out of existence. Among economists, the no-arbitrage
principle has essentially attained the status of religion. There is a good reason
for this. In particular, the idea that unexploited riskless profit opportunities
exist for any relevant length of time seems almost impossible to imagine.
Now let us consider the following two assets, both of which are issued by
the government. One asset is called a bond, and the other is called money. A
bond represents a claim against future money. But then, money also represents
a claim against future money. If I hold B dollars of one-year government bonds,
at the end of the year these bonds are transformed into Rn B dollars. If instead
I hold M dollars of government money, at the end of the year this money is
‘transformed’ into M dollars (since paper money does not pay interest). In
other words, government money is just another type of government bond; i.e.,
it is a bond that pays zero nominal interest.
What is interesting about this example is that it appears (on the surface at
least) to violate the no-arbitrage principal (at least, assuming that government
bonds are free of nominal risk). Why do people choose to hold government
money when money is so obviously dominated in rate of return? Are individ-
uals irrational? Why is this rate of return differential not arbitraged away?
Alternatively, why do government bonds not drive government money out of
circulation?
The explanations for this apparent violation of the no-arbitrage principle fall
under two categories. The first category is one that you’ve probably thought
of already. The argument goes something like this. Government money is a
‘special’ type of asset. In particular, it is a ‘liquid’ asset, whereas a government
bond is not. For example, just try buying a cup of coffee (or anything else)
with a government bond. Thus, while the pecuniary (i.e., monetary) return
on money may be low, money confers a non-pecuniary return in the form of
‘liquidity’ services. Thus, observing differences in the pecuniary rates of return
between money and bonds is not necessarily a violation of the no-arbitrage
principle; i.e., the apparent gap between these two returns may simply reflect
the non-pecuniary return on money.
The argument just stated sounds compelling enough to most people. But
upon further examination, it appears unsatisfactory. In particular, the explana-
tion simply asserts that government money is a ‘special’ asset without explaining
why this might be the case. It does refer to the idea that money is ‘liquid,’ but
fails to define the term or explain what it is about money that makes it ‘liquid.’
Furthermore, it is not at all apparent that such a rate of return differential could
not be arbitraged away by the banking system. For example, a bank should, in
principle, be able to purchase a government bond and then create its own paper
money ‘backed’ by such an instrument. Banks could make huge profits by print-
ing zero interest paper while earning interest on the bond it holds in reserve.
Competition among banks would then either compel them to pay interest on
their money, or drive the interest on bonds to zero.11
11 A small interest rate differential may remain reflecting the cost of intermediation.
8.6. A RATE OF RETURN DOMINANCE PUZZLE 183
You might object to this argument on the ground that while the idea sounds
good in principle, in practice banks are legally prevented from issuing their own
paper money (since 1935 in Canada). Good point. In fact, such a point repre-
sents the legal restrictions hypothesis for why government money is dominated
in rate of return (Wallace, 1983).
So now you agree that there is nothing particularly ‘special’ about govern-
ment paper money. Private banks can issue paper money too (and have done so
in the past). What prevents banks from doing so today is largely the product of
a legal restriction (i.e., the government wishes to maintain a monopoly over the
paper money supply). Government bonds are not useful for payments because
they are either: [1] issued in very large denominations (e.g., $10,000 or more); or
[2] they exist only as electronic book-entries (as is mainly the case these days).
Thus, the no-arbitrage principle is not violated because the principle only holds
in the absence of government trade restrictions.
As a corollary, the legal restrictions hypothesis predicts that the rate of
return differential between money and bonds would disappear if one of the
following two government reforms were implemented. First, if the government
(in particular, the treasury or finance department) began to issue paper bonds
in the full range of denominations offered by the central bank. Second, if the
government was to alter legislation that prevented banks (or any other private
agency) from issuing its own paper money.12
8.6.1 The Friedman Rule

Is inflation/deflation ‘good’ or ‘bad’ for the economy? While we have not, as of
yet, developed a model that is capable of examining the welfare implications of
inflation, it is nevertheless useful at this stage to ponder the question for what
lies ahead.
An extremely robust result in most economic models is that economic effi-
ciency (in the sense of Pareto optimality) requires that no-arbitrage conditions
be satisfied. Let us consider the real rates of return on two types of assets: gov-
ernment money and risk-free capital (if such a thing exists).13 The real return
on capital is R. The real return on money is 1/Π (since money is like a zero
interest nominal bond). The no-arbitrage principle then asserts that efficiency
requires:
1
= R. (8.6)
Π
Equation (8.6) is the celebrated Friedman rule. Recall from the Fisher equa-
1 2 While either reform is likely to generate rate of return equality between money and bonds,
we cannot say (without further analysis) whether the nominal return will be positive or zero.
1 3 The demand deposit liabilities of modern-day chartered banks perhaps constitute an ex-
ample.
tion (8.5) that the nominal interest rate is given by Rn = RΠ. Hence, the
Friedman rule is asserting that an optimal monetary policy should operate in a
manner that drives the (net) nominal interest rate to zero; i.e., RΠ = 1. If R > 1
(as is normally the case), then this policy recommends engineering a deflation;
i.e., Π = 1/R < 1. If R < 1 (as may be the case in present day Japan), then
this policy recommends engineering an inflation; i.e., Π = 1/R > 1. Price-level
stability (zero inflation) is only recommended when the (net) real interest rate
is zero.
Since the Friedman rule is based on a no-arbitrage principle, it is difficult
to dispute it’s logic. Nevertheless, almost no one in policy circles takes the
Friedman rule seriously. Central bankers, in particular, appear to be highly
averse to the idea of a zero nominal interest rate. The reasons for why this
might be the case will be explored in a later chapter. But for now, we must
simply regard any departure from the Friedman rule as an unresolved ‘puzzle.’
8.7 Inflation Uncertainty

If inflation was always easily forecastable, then it is hard to imagine how (at
least moderate) inflations or deflations may pose a pressing economic problem
(at least, relative to all the other things we have to worry about). Nominal
prices could in this case be contractually agreed upon in a way that leaves the
underlying ‘real’ prices (including wages and interest rates) at their ‘correct’
levels.
Of course, inflation is not always easily forecastable. This appears to be
especially true for economies experiencing very high rates of inflation. It is a
fact of life that most real-world contracts are stated in nominal terms and that
these terms depend, at least in part, on the forecast of inflation. If inflation
is highly variable, it is not easy for nominal contracts to ensure the ‘proper’
allocation of real resources. Unexpected inflation is viewed as being undesirable
for two reasons. First, if contracts are not indexed to inflation (normally, they
are not) and if contracts are costly to renegotiate (as is surely the case), then
an unexpected inflation results in a redistribution of resources (for example,
from creditors to debtors). Second, if indexation and/or renegotiation is costly,
then inflation uncertainty is likely to entail resource costs and the curtailment
of economic activity.
These are the primary reasons for why it is a stated policy of many central
banks to keep inflation ‘low and stable.’14 To this end, many central banks have
adopted an inflation target. The Bank of Canada, for example, has (since 1991)
adopted an inflation target of 2% (not the Friedman rule!) with an operating
band of plus/minus 1%; i.e., see Figure 8.4. The general consensus appears to
be that inflation targets work well toward the goal of keeping inflation ‘low and
1 4 See, for example, www.bankofcanada.ca/ en/ inside.htm
8.8. SUMMARY 185
stable.’15
Figure 8.4
Bank of Canada Inflation Target
8.8 Summary
Money is an asset whose role is to record individual transactions. In its role as
a record-keeping device, money serves to facilitate exchange, and hence improve
economic welfare.
Money exists in two basic forms: small denomination paper and electronic
book-entry. In most modern economies, the government (via a central bank)
maintains monopoly control over the supply of small denomination paper, while
the private sector (via the banking system) is left to determine the supply of
book-entry money. Since the vast majority of money is in the form of book-
entry, it is not clear to what extent a government can control the total supply of
money (the sum of paper and book-entry money). In practice, however, various
legal restrictions on the banking sector likely imply that the government can
exert some influence on the supply of book-entry money (and hence, the total
money supply).
To understand the behavior of nominal variables, one must have a theory
that includes some role for money. But since economic welfare depends ulti-
mately on real variables, the study of money (and monetary policy) is only
1 5 The interested reader can refer to Bernanke, Laubach, Mishkin and Posen (1999).
relevant to the extent it influences real economic activity. In the neoclassical

model, money may be important for economic efficiency, but money itself is not
a source of economic disturbance nor do monetary factors influence the way an
economy responds to other shocks.
The neoclassical view of money may provide a good approximation for some
historical episodes in which the money supply was almost entirely provided by a
relatively free and competitive banking system (e.g., the Scottish and U.S. ‘free-
banking’ eras). There is, however, a considerable ongoing debate of this issue.
In any case, in most modern (and historical) economies, the government exerts
at least some control over money supply. Furthermore, various ‘contracting
frictions’ may be severe enough to render money non-neutral, so that ‘shocks’ to
monetary policy may potentially constitute an important source of the business
cycle. Even in the absence of monetary policy shocks, these ‘frictions’ may
influence the way an economy responds to other types of disturbances.
8.9 Problems
1. Consider the Wicksellian model in Figure 8.1. One way to imagine trade
taking place is as follows. First, B makes a ‘gift’ to A. Second, C makes a
‘gift’ to B. Finally, A makes a ‘gift’ to C. If society could keep a complete
record of such gifts, would there be any role for money? Explain how
money can be thought of as a substitute for such a public record-keeping
technology.
2. We are often counselled by financial planners to set aside at least a part

of our saving in the form of ‘safe’ government bonds and money (cash).
Explain why money and bonds are not risk-free debt instruments in the
future rate of inflation is uncertain.
3. Many macroeconomic textbooks make reference to the notion of a ‘mon-

etary policy shock.’ Does this concept make any sense to you? Why, in
particular, would a monetary authority want to ‘shock’ the economy? Or
is there some other way of interpreting such a shock? Discuss.
8.10 References
1. Bernanke, Ben S, Thomas Laubach, Frederic S. Miskin and Adam S. Posen
(1999). Inflation Targeting: Lessons from the International Experience,
Princeton University Press, Princeton, New Jersey.
2. Laidler, David E. W. (1985). The Demand for Money, Harper & Row,
Publishers, New York.
3. Smith, Bruce D. (1985). “American Colonial Monetary Regimes: The

Failure of the Quantity Theory and Some Evidence in Favour of an Alter-
native View,” Canadian Journal of Economics, XVIII(3): 531—565.
4. Wallace, Neil (1983). “A Legal Restrictions Theory of the Demand for
‘Money’ and the Role of Monetary Policy,” Federal Reserve Bank of Min-
neapolis Quarterly Review, 7(1): 1—7.
Chapter 9
The New-Keynesian View
9.1 Introduction
Many economists and policymakers do not believe that money is neutral, at

least, in the ‘short-run.’ To take this view, one must believe the following two
things: [1] that the economy’s relevant money supply is determined (or at least,
greatly influenced) by policy; and [2] that ‘contracting frictions’ are present
that make at least some nominal variables ‘sticky;’ at least, for ‘short, but
sufficiently long’ periods of time. The term ‘sticky’ is meant to capture the idea
that some nominal variables do not react ‘immediately’ to shocks (in particular,
monetary policy shocks). A prominent and influential strand of the literature
that emphasizes the importance of sticky nominal prices operates under the
label ‘New-Keynesian’ economics.1
9.2 Money Non-Neutrality
New Keynesian models typically feature either sticky prices or sticky wages, but
not both. I am not sure what accounts for this either or treatment. Perhaps it
is because if both prices and wages are sticky, then real wages would be sticky,
and generating money non-neutrality may be more difficult. In what follows, I
consider a model with sticky wages.
1 The label ‘New-Keynesian’ is somewhat ironic in light of the fact that Keynes (1936)
appeared to take the view that nominal prices ‘too’ flexible and destabilizing. For example, a
rapid decline in product prices might lead to a ruinous ‘debt-deflation’ cycle (as falling prices
would increase real debt burdens). Likewise, rapidly falling nominal wages contribute to a
decline in demand that would exacerbate an economic downturn.
189
190 CHAPTER 9. THE NEW-KEYNESIAN VIEW
9.2.1 A Basic Neoclassical Model
To begin, consider the neoclassical model of the labor market, for example,
as developed in Appendix 2.A. Profit maximization there implies a downward
sloping labor demand function nD (w), where w denotes the real wage. Utility
maximization on the part of households implies an upward sloping labor supply
function (assuming that the substitution effect dominates the wealth effect for
real wage changes) nS (w). In a neoclassical equilibrium, the equilibrium real
wage and employment are determined by nS (w∗ ) = nD (w∗ ) = n∗ . This level of
employment generates a ‘natural’ level of real GDP; y ∗ = F (n∗ ).
Now, to introduce money into the model, let us appeal to the Quantity The-
ory of Money, which asserts that for a given money supply M, the equilibrium
price-level is determined by P ∗ = M/y ∗ ; i.e., see Chapter 8. The equilibrium
nominal wage is then given by W ∗ = w∗ P ∗ .
Figure 9.1 depicts the neoclassical equilibrium graphically. The figure depicts
an ‘aggregate supply’ (AS) function and an ‘aggregate demand’ (AD) function.
These labels are perhaps not the best ones available, since these ‘supply’ and
‘demand’ functions do not correspond to standard microeconomic definitions.
The way to think of the AS curve is that it represents all the output-price
combinations that are consistent with equilibrium in the labor market. Since
equilibrium in the labor market does not depend on the price-level, the AS
curve is horizontal. The way to think of the AD curve is that it represents all
the output-price combinations that are consistent with equilibrium in the money
market (for a given level of M ). The AD curve slopes downward from left to
right because a higher price-level reduces the supply of real money balances,
which implies that a lower level of output is need to clear the money market.
When the money supply is equal to M0 , the general equilibrium occurs at point
A, where both the labor and money market are in equilibrium. An exogenous
increase in the money supply to M1 > M0 moves the economy to point B,
leaving all real variables unchanged. In other words, money is neutral.
9.2. MONEY NON-NEUTRALITY 191
FIGURE 9.1
Response to a Money Shock: Neoclassical Model
A B
y* AS
AD(M1)
AD(M0)
0 P*0 P*1 P
9.2.2 A Basic Keynesian Model

From a New-Keynesian perspective, point A in Figure 9.1 represents how an
economy might be expected to behave in the ‘long-run’ (i.e., the amount of
time it takes nominal prices and wages to adjust to their equilibrium levels). In
the ‘short-run,’ however, the economy may react quite differently to a money
supply shock.
Imagine, for example, that workers negotiate a nominal wage contract of
the following form. Workers agree to supply all the labor that is demanded
from them at some given nominal wage W. The nominal wage is not indexed
to the price-level. Nor can this nominal wage be renegotiated in the ‘short-
run.’ The lack of indexation or renegotiation poses no problem if the price-level
remains constant over time. Perhaps this is one way to rationalize a non-indexed
wage. That is, if workers expect the price-level to remain relatively stable over
time, there is no sense in negotiating (costly) indexation clauses into their wage
contract.
With labor supply modeled in this way, the level of employment is deter-
mined solely by labor demand; i.e., nD (w), where w = W/P. Notice that for a
fixed nominal wage W, the demand for labor is increasing in the price-level. This
is because a higher price-level reduces the real wage, and hence, the real cost of
labor to firms. Consequently, it follows that the AS curve is—in the ‘short-run’
£ at
¤
least—an increasing function of the price-level; i.e., y S (W/P ) = F nD (W/P ) .
Let us label this relationship as the SRAS (short-run aggregate supply) function.
The AD relationship is as before. Together the SRAS and the AD curve are
plotted in Figure 9.2. Assume that the wage is initially fixed at it’s neoclassical
level; i.e., W = W ∗ . In this case, the equilibrium is given by point A. At this
point, the economy is said to be both in a ‘short’ and ‘long’ run equilibrium.
Now, imagine that the money supply is unexpectedly increased (for some
unexplained reason). Then the AD curve shifts ‘up’ as in Figure 9.1. As in the
neoclassical model, the effect of this shock is to put upward pressure on the price-
level. However, unlike the neoclassical model, we see here that the level of output
(and employment) rises as well; i.e., in the ‘short-run,’ the economy moves to
point C in Figure 9.2. The level of output increases because the expansion
in money supply ultimately reduces real labor costs (since the nominal wage
is fixed and since prices are higher). In other words, money is not neutral—at
least, in the ‘short-run.’ In the ‘long-run,’ one can imagine that workers would
react to this development by demanding higher wages (i.e., W1∗ > W0∗ ). As
this process unfolds, the SRAS shifts back ‘down,’ and the economy eventually
moves to point B.
FIGURE 9.2
Response to a Money Shock: Keynesian Model
SRAS(W0*/P)
C SRAS(W1*/P)
A B
y* AS
AD(M1)
AD(M0)
0 P*0 P*1 P
• Exercise 9.1. Consider Figure 9.2 and imagine that the economy is
initially at point A. Now, imagine that the economy experiences a positive
productivity shock. The effect of this shock is to shift the AS and SRAS
‘up’ by the same distance.
9.3. THE IS-LM-FE MODEL 193
(a) Assuming that M remains fixed, explain how the economy reacts both
in the short and long run (it will be helpful to first work through the
neoclassical case).
(b) How might a monetary authority react to such a shock to facilitate the
transition to the higher long-run level of output? What implications
would such a policy have for the price-level? Is such a policy likely
to improve welfare? Explain.
9.3 The IS-LM-FE Model

In order to set up the discussion that follows in the next section, it will be
useful to present an extension to the basic Keynesian model developed above.
The extension involves introducing a role for the interest rate. As we know from
earlier chapters, an interest rate is an intertemporal price. Proper modeling of
the interest rate should entail an explicit description of the economy’s dynamic
structure. But developing an explicitly dynamic model with sticky prices in-
volves a complicated analysis. For this reason, we follow convention and employ
a number of ‘short-cuts’ by favoring intuitive arguments over rigorous derivation.
The basic intuition, however, will survive a more rigorous theoretical treatment.
The extended model is called the IS-LM-FE model and is essentially an
extension of the basic Keynesian AS-AD model developed above. The IS-LM-
FE version highlights the relationship between output and the interest rate.
The extended AS-AD version highlights the relationship between output and
the price-level. Both versions constitute the same model presented graphically
in different spaces; i.e., (y, R) space versus (y, P ) space.
In what follows, we will take R to denote both the real and nominal interest
rate. From the Fisher equation, we know that this will only be true if expected
inflation is zero. All that we really need, however, is to assume that inflation
expectations are ‘sticky’ in the short-run. But for simplicity, it is assumed here
that inflation expectations are fixed at zero.
9.3.1 The FE Curve

FE stands for ‘Full Employment.’ The FE curve is defined as the combination
of (y, R) that are consistent with equilibrium in the labor market for a given
P. If intertemporal market forces are relatively weak as far as the current labor
market is concerned, then we can essentially stick to the ‘static’ labor market
model developed above. In this case, equilibrium in the labor market is inde-
pendent of (among other things) the interest rate. Hence, if we draw a graph
with y on the y-axis and R on the x-axis, the FE curve is horizontal. That is,
the FE curve consists of the the (y, R) combinations that satisfy:
y ∗ = F (n∗ ); (9.1)
where n∗ is determined by nS (w∗ ) = nD (w∗ ) = n∗ .

If the nominal wage is sticky, however, there is also a ‘short-run’ FE curve
(SRFE) that will depend on W and P. This is just the analog of the SRAS curve
discussed earlier. For a fixed W, an increase in P will shift the SRFE curve ‘up;’
and a decrease in P will shift the SRFE curve ‘down.’ All this tells us is that
in the short-run, the supply of output is increasing in the price-level; i.e., the
SRAS curve is an increasing function of P. The SRFE curve consists of all the
(y, R) combinations that satisfy:
£ ¤
y S (W/P ) = F nD (W/P ) . (9.2)
Note that the SRFE curve does not depend on R (although, its position will
shift with changes in W or P that alter the real wage (W/P ).
9.3.2 The IS Curve

IS stands for ‘Investment-Saving.’ The IS curve is defined as the combination of
(y, R) that are consistent with equilibrium in the (intertemporal) goods market.
In a closed economy, this requires that desired national investment xD is equal
to desired national saving sD (hence, investment-saving or IS curve).
Chapter 4 discusses at length all the factors that may influence consumer
demand (and hence, desired saving). The analysis here simplifies by assuming
that desired saving depends primarily on current income y; i.e., sD (y). For
this to make sense, the view must be that any fluctuation in current income is
transitory.2
Chapter 6 discusses at length all the factors that may influence investment
demand. The analysis here utilizes what we learned there and assumes that
investment demand depends negatively on the interest rate R and positively on
an ‘expectation parameter’ z e ; i.e., xD (R, z e ). In Chapter 6, z e reflected the
private sector’s forecast of the future return to capital spending. You can think
of z e as shifting for either ‘rational’ or ‘exogenous’ reasons (the Keynesian view
prefers the latter interpretation).
Equilibrium in the goods market requires:
sD (y) = xD (R, z e ). (9.3)
The IS curve simply represents all the (y, R) combinations that satisfy equation
(9.3) for a given z e . Sometimes, the level of y that satisfies (9.3) is called the
aggregate demand for goods and services (not to be confused with the AD curve).
• Exercise 9.2. Explain why the aggregate demand for goods and services
(output) depends negatively on R.
2 Recall from Chapter 4 that an income change that is perceived to be permanent is not
likely to influence desired saving by very much.

From the previous exercise, it follows that y and R are negatively related to
each other (for a fixed z e ).
• Exercise 9.3. Explain how the aggregate demand for goods and services
depends on z e (explain the economics; do not just describe the mechanics).
9.3.3 The LM Curve

LM stands for ‘Liquidity preference - Money supply.’ Here, ‘liquidity preference’
refers to the demand for money. The LM curve is defined as all the (y, R)
combinations that are consistent with equilibrium in the money market, for a
given supply of real money balances M /P. As such, it bears some resemblance to
the AD curve derived earlier, where equilibrium in the money market required
M = P y. Under this version of the Quantity Theory, however, the money market
does not depend on R. This is because the simple version of the QTM assumes
that the demand for real money balances L depends primarily on real income;
i.e., L(y) = y.
An intuitive argument can be made, however, that the demand for money
should depend on R as well, leading us to write L(y, R). The presumption is
that money demand should depend negatively on the nominal rate of inter-
est. In particular, since money earns no interest, the interest rate reflects the
opportunity cost of holding money. A higher interest rate is likely to compel
individuals to economize on their money holdings (preferring to hold a greater
fraction of their wealth in the form of interest-bearing bonds).
Equilibrium in the money market can therefore be expressed by:
M
= L(y, R). (9.4)
P
The LM curve represents all the (y, R) combinations that satisfy equation (9.4),
for a given (M/P ). Since L is an increasing function of y and a decreasing
function of R, it follows that y and R are positively related. That is, since
a higher level of income increases money demand, the interest rate must then
increase to bring money demand back down to a fixed level (M/P ).
9.3.4 Response to a Money Supply Shock: Neoclassical

Model
As before, it is useful to describe the general equilibrium of this model under
the assumption that wages and prices are flexible (the neoclassical assumption).
The resulting equilibrium can then be interpreted as a ‘long-run’ scenario.
The general equilibrium of the model consists of a scenario in which the labor,
goods, and money market are all in equilibrium simultaneously. Mathematically,
the model consists of three equations (IS-LM-FE) and three unknowns (y, R, P ).
We want to find a combination of (y, R, P ) that satisfy all three equations

simultaneously. Such an equilibrium is depicted as point A in Figure 9.3.
FIGURE 9.3
General Equilibrium: Neoclassical Model
LM(M/P*)
A
y* FE
IS(ze)
0 R* R
In the neoclassical model, an increase in M generates a proportional increase

in P (and W ), leaving the position of the LM curve unchanged. A money supply
shock has no effect on either output or the interest rate; the only effect is raise
nominal prices and wages. Money is neutral.
• Exercise 9.4. Imagine that the economy receives an ‘aggregate demand’

shock (i.e., an increase in z e ). Use the logic embedded in Figure 9.3 to
argue that such a shock will: (a) leave current output unchanged; (b)
increase the interest rate; and (c) increase the price-level. Explain the
economics.
• Exercise 9.5. Note that the IS-LM-FE analysis is ill-equipped to isolate

the ‘long-run’ effects associated with a current period change in z e . For
example, if z e has increased this period because individuals are forecasting
higher future productivity and if such expectations are correct, higher
future productivity will increase the supply of output (shifting the future
FE curve ‘up’). To the best of your ability, use Figure 9.3 to demonstrate
what the future equilibrium may look like.
9.3.5 Response to a Money Supply Shock: Keynesian Model
In the Keynesian model, the economy’s ‘long-run’ general equilibrium position

corresponds to the neoclassical case; i.e., point A in Figure 9.3 (i.e., the SRFE
curve lies on top of the FE curve). However, if the nominal wage is sticky,
money will again be non-neutral in the short-run.
To see how things work here, consider an exogenous increase in the money
supply, say from M0 to M1 . The effect of this shock is to shift the SRFE curve
‘up.’ That is, for a fixed nominal wage, the resulting increase prices will lower
the real cost of labor, hence expanding the supply of output (in the short-run).
Note, however, that the initial increase in the price-level is not as large
as it would have been in the neoclassical model. This is because the short-
run increase in output dampens the price-level response. Since the price-level
does not initially rise in proportion to the money supply, the supply of real
money balances increases, say, from (M0 /P ∗ ) to (M1 /P 0 ), where P 0 > P ∗ . This
increase in real money balances shifts the LM curve ‘up,’ so that the short-run
equilibrium is given by point B in Figure 9.5.
The way a New-Keynesian economist would explain the economics of what
is happening here is as follows. The sudden injection of new money leads to
a liquidity effect that lowers the interest rate (both real and nominal). This
liquidity effect occurs because the supply of real money balances increases (ow-
ing to the partial adjustment in the price-level, brought about by the sticky
nominal wage). The lower interest rate then stimulates the aggregate demand
for goods and services (the movement up along the IS curve). As the demand
for output increases, firms hire more workers to meet the demand (the shift up
in the SRFE curve).
In the ‘long-run,’ (the time it takes workers to renegotiate their nominal
wages upward), the nominal wage will rise to its (neoclassical) equilibrium level.
This increase in labor costs compels firms to scale back on employment and the
supply of output (i.e., the SRFE curve shifts back down to it’s original level).
The subsequent contraction in output puts further upward pressure on the price-
level (shifting the LM curve back down to it’s original level). In the long-run,
money is neutral (the equilibrium level of output returns to its ‘natural’ level).
FIGURE 9.4
The Liquidity Effect of a Money Supply Shock
y LM(M1 /P’)
LM(M0 /P*)
B
SRFE(W/P’)
A
y* FE
IS(ze)
0 R* R
Perhaps one reason why policymakers (central bankers in particular) ‘like’

the New-Keynesian model is because it implies that monetary policy can influ-
ence real economic activity—at least, in the short-run. The idea that a central
bank might exert such influence is comforting to those who view markets as
working ‘imperfectly’ (sticky nominal variables) and perhaps subject to ‘irra-
tional’ fluctuations in ‘aggregate demand.’ According to the New-Keynesian
model, the central bank can and should vary its interest rate (money supply)
policy to keep the economy as close as possible to its ‘natural’ level of activity.
• Exercise 9.6. Suppose that the economy is initially at its general equi-
librium (i.e., point A in Figure 9.4). Imagine further that the economy is
subject to an ‘aggregate demand’ shock (i.e., an increase in z e ).
(a) Use the logic embedded in Figure 9.4 to work through how the econ-
omy may react to such a disturbance, both in the short and long-run.
(b) Suppose that a central bank interprets the shock as ‘irrational exu-
berance’ on the part of the private sector. Explain how the central
bank could increase the interest rate to a point that stabilizes GDP
at its ‘natural’ level. Would it be welfare improving for the central
bank to act in this manner? Explain.
9.4. HOW CENTRAL BANKERS VIEW THE WORLD 199
9.4 How Central Bankers View the World
The IS-LM-FE model developed above captures many of the basic principles that
appear to be held by central bankers around the world. The actual theoretical
framework employed, however, is an extension of the IS-LM-FE model. The
extension involves providing some link between inflation (as opposed to the
price-level), inflation expectations, and output. Below, I describe the basic
setup of this extended model.
9.4.1 Potential Output
Potential output is defined as that level of output that would be produced in

the absence of any nominal rigidities.3 In a neoclassical model, the economy is
always producing ‘at potential.’ In a New-Keynesian model, the economy may
not be producing at potential; e.g., as in point B in Figure 9.4.
Note that potential output is a theoretical object; i.e., it is not as if we can
simply look at an economy and observe it’s potential output. Potential output
must be estimated within the context of a particular theory. The theory adopted
by central bankers (largely shared by New-Keynesians) is that potential output
grows relatively smoothly over time. Implicit in this view is that the process
of technological development occurs in a relatively smooth manner (in contrast
to the neoclassical perspective). Furthermore, while various real shocks (like a
sudden increase in the world price of oil) may cause shifts in potential output,
this source of variability plays a relatively minor role (at least, most of the
time) in explaining the business cycle (again, this in contrast to the neoclassical
perspective).
Thus, potential output corresponds in some way to an economy’s ‘trend’ level
of GDP. The way that one can estimate potential output then is to associate it
with the statistical trend line running through measurements of the economy’s
actual GDP growth pattern; for example, as in Figure 9.5.
3 Potential output is sometimes also referred to as the ‘natural’ level of output.

FIGURE 9.5
Actual and Potential Output Output Gap

10.8 4
3
Percent Deviation from HP Trend

10.7
2
10.6 Positive 1
Output Gap
Log Scale
0
10.5
-1
10.4 -2
-3
10.3 Negative
Output Gap
-4
10.2 -5
1970 1975 1980 1985 1990 1995 2000 1970 1975 1980 1985 1990 1995 2000
Real per capita GDP Potential GDP (HP Trend)
Figure 9.5 suggests that the economy is not usually functioning at potential.
The difference between actual and potential output is called the output gap. A
negative output gap tends to emerge as an economy enters a recession. A pos-
itive output tends to emerge after a period of prolonged expansion. Since the
(theoretical) output gap can only emerge as a consequence of nominal rigidities,
the business cycle here is naturally viewed as being something ‘bad;’ i.e., the
product of a less than perfect market economy. In the ‘long-run,’ nominal prices
adjust to move the economy back to potential. But in the ‘short-run,’ various
shocks to the economy can move the economy away from potential. Since real
shocks are presumed to play a relatively minor role, it follows that ‘aggregate de-
mand’ shocks must constitute the primary source of economic volatility. Hence,
to the extent it is possible, policy should endeavor to stabilize the business
cycle.4
In terms of the theory developed early, you can think of potential (or the
‘natural’ level) of output as being determined by the neoclassical FE curve. Let
yt∗ denote potential output at date t.
4 It is interesting to contrast the New-Keynesian interpretation of the business cycle with
the neoclassical perspective. According to the latter view, economic fluctuations are primarily
the product of the natural process of economic development. The market system is viewed as
working reasonably well (so that nominal rigidities are not quantitatively important). Accord-
ing to this view then, the economy is always at (or close) to ‘potential.’ The so-called ‘trend’
line and ‘output gap’ identified in Figure 9.5 then is merely the by-product of a statistical
detrending procedure. One cannot conclude, on the basis of drawing a smooth line through
the data, that this smooth line necessarily corresponds to any theoretical object. (It is debates
like these that make macroeconomics so interesting).
9.4.2 The IS and SRFE Curves

While the economy’s potential output is determined by the FE curve, the actual
level of output is determined by the IS and SRFE relationships. The way this
is usually written is as follows:
yt − yt∗ = −δ (Rt − R∗ ) + et . (9.5)
The term (yt − yt∗ ) represents the output gap. The term (Rt − R∗ ) denotes
an ‘interest rate gap.’ In this latter expression, you can think of R∗ as being
determined by ‘long-run’ neoclassical considerations; so that R∗ can be thought
of as the ‘natural’ rate of interest. As is the case with output, the actual (real)
interest rate may differ from its natural rate. The relationship in (9.5) asserts
that the output gap is negatively related to the interest rate gap, where δ > 0
is just a parameter that indexes the strength of this relationship. The equation
(9.5) actually combines the IS and SRFE relationships together. It has the flavor
of an IS curve because equilibrium in the goods market requires that (yt , Rt ) be
negatively related to each other (i.e., an increase in the interest rate lowers the
aggregate demand for goods and services). But since yt has the interpretation
of being the actual level of output (as opposed to just the theoretical demand
for output), implicit in (9.5) is the idea that firms actually deliver the output
demanded (i.e., the economy is on the SRFE or SRAS curve).
The term et in (9.5) is meant to represent an ‘aggregate demand shock.’
One interpretation of this shock is that it reflects ‘animal spirits’ that lead to
exogenous fluctuations in investment demand. Alternatively, one can think of
et as representing an exogenous government spending shock.
9.4.3 The Phillips Curve

The Phillips curve provides a link between inflation and output. The way this
is usually written is as follows:
Πt = Πet + φ (yt − yt∗ ) + ut . (9.6)
Equation (9.6) asserts that the inflation rate is determined in part by expected
inflation, the output gap, and possibly other forces (’inflation shocks’).
In the IS-LM-FE model studied above, a positive ‘aggregate demand shock’
(e.g., an increase in z e ) tends to put upward pressure on the price-level. This
same shock is also likely to drive actual output above potential; see Exercise
9.6. This type of reasoning suggests that there is a positive relationship between
inflation and the output gap; i.e., φ > 0.
The idea that expectations of inflation may influence the actual inflation rate
is something we touched on briefly in Section 8.3.1. (the discussion there was
in terms of the price-level). In particular, if the money supply is endogenous
in the sense of being determined entirely by the demand for money at a given
interest rate (as will be the case in this model), then there is an element of
nominal indeterminacy present. In particular, an expected inflation can become
a self-fulfilling prophesy.5
Precisely how inflation expectations are modeled appears to vary across dif-
ferent New-Keynesian models. One view holds that expectations are ‘backward-
looking’ in the sense that people form their expectations of inflation primarily
on a recent history of actual inflation rates. Another view holds that expecta-
tions are ‘forward-looking’ in the sense of depending on (among other things)
the entire future path monetary policy actions. Some New-Keynesian models
embody both backward and forward looking elements. For our purpose, the
simplest thing to assume is backward-looking behavior; for example:
Πet = Πt−1 . (9.7)
In this case, the Phillips curve relationship in (9.6) may be rewritten as follows:
Πt = Πt−1 + φ (yt − yt∗ ) + ut . (9.8)
Figure 9.6 plots the ‘inflation gap’ (Πt −Πet ) against the output gap (yt − yt∗ )
for the U.S. economy (1970.1—2003.3).6 Empirically, the Phillips curve relation-
ship does not appear to be as tight as one might like, although there is a positive
correlation (0.196) between the gap measures.
Figure 9.6: Phillips Curve
8
6
Inflation Gap
0
-6 -4 -2 -2 0 2 4 6
-4
Output Gap
5 In some New-Keynesian models, expected inflation influences actual inflation through a
strategic complementarity that is present in the pricing decisions of monopolistically compet-

itive firms.
6 In Figure 9.6, I use the Livingston survey of inflation expectations for my measure of Πe .
t
As for the ‘inflation shock’ term ut , I am not very clear as to what this
is supposed to represent in reality.7 Perhaps one way to think of this shock
is as influencing the formation of inflation expectations; i.e., Πet = Πt−1 + ut .
Such an interpretation is not entirely inconsistent with the perception of some
central bankers that inflation expectations have partly a life of their own (i.e.,
are driven in part by animal spirits).
9.4.4 Monetary Policy: The Taylor Rule

Central bankers view themselves not as determining the money supply, but as
determining ‘the’ nominal interest rate Rtn . Given this choice of interest rate,
the money supply is determined endogenously by the private sector’s demand
for money. In effect, the LM curve becomes vertical in Figure 9.4).
Of course, Figure 9.4 depicts the real interest rate on the x-axis. A change
in the nominal interest rate will only affect the real interest rate to the extent
that inflation expectations do not move one-for-one with changes in the nominal
rate. Given our assumption concerning inflation expectations in (9.7), this will
in fact be the case. In the short-run then, the nominal and real interest rates
move together; i.e., from the Fisher equation, Rt = Rtn /Πet .
The central bank is imagined to have a long-run inflation target Π∗ , which
serves as a ‘nominal anchor’ (in the absence of such a target, the equilibrium
inflation rate would be indeterminate).
Now, imagine that there were no shocks in this economy; i.e., et = ut = 0, for
all t (with yt evolving in a smooth and deterministic manner). In the absence of
any shocks, it makes sense to think of inflation expectations as being determined
by the inflation target; i.e., Πe = Π∗ . Then, given the inflation target Π∗ , the
best a central bank can do is to set the nominal interest rate to a level that
would prevail in the neoclassical model; i.e., Rn = Π∗ R∗ . In such a world, the
level of output would always be at potential.
• Exercise 9.7. What would happen in such a world if the central bank
lowered the nominal interest rate below Π∗ R∗ (say, for one period)?
• Exercise 9.8. Suppose that the central bank wished to lower its inflation
target. Explain how the central bank could achieve this goal, but at the
cost of a recession.
Now, imagine that the economy is inflicted with ‘aggregate demand shocks’
et . Consider, for example, an exogenous increase in aggregate demand. For a
given interest rate (both real and nominal), the effect of this shock is expand
7 These shocks are sometimes referred to as ‘mark-up shocks,’ which influence the pricing-
decisions of monopolistically competitive firms. I would appreciate someone providing me

some good real-world examples of a ‘mark-up’ shock as well as evidence suggesting their
importance for driving business cycle behavior.
output and the price level (since the nominal wage is rigid). The expansion in
output above potential is welfare-reducing. Furthermore, the surprise increase in
the price-level is inflationary (i.e., since actual inflation is higher than expected,
individuals subsequently update their inflation expectations to a higher level—
which generates a permanently higher inflation rate). To bring the inflation
rate back down to the target level, the central bank would have to generate a
recession; i.e., re: Exercise 9.8. The way in which a central bank may prevent
all of this from happening is to respond to the aggregate demand shock by
temporarily increasing the interest rate. Such a response would ‘frustrate’ the
‘excess demand’ and ‘inflationary pressure’ brought on by the aggregate demand
shock.8
If aggregate demand shocks were the only shocks hitting an economy, then
the central bank’s job would be relatively easy. That is, it would simply increase
the interest rate when it observed output increasing beyond potential, and de-
crease the interest rate when output it observed output moving below potential.
Such a policy would stabilize both output and inflation.
But if there are other shocks hitting the economy, then the central bank’s
job is not so straightforward. Consider, for example, the arrival of a positive
‘inflation shock’ ut . Left unchecked, the effect of such a shock would be to
increase the inflation rate permanently (via the adjustment in expectations).
From the Phillips curve relation (9.8), we see that the only way to keep the
inflation rate stable when ut > 0 is to make (yt − yt∗ ) < 0. In other words,
to stem the inflationary pressure of an inflation shock, the central bank must
raise the interest rate, thereby generating a recession (to ‘cool off’ aggregate
demand). Any long-term benefit from maintaining the inflation target at Π∗
must therefore be weighed against the short-run cost of making output move
away from potential.
In sum, we see that when both types of shocks are operating, the central
bank faces a trade-off between stabilizing output (around potential) and sta-
bilizing the inflation rate (around the inflation target). A central bank that is
more concerned with stabilizing output will be less concerned about controlling
inflation. In a sense, such policy places more weight on the ‘short-run’ relative
to the ‘long-run.’ Conversely, a central bank that is more concerned with stabi-
lizing the inflation rate will be less concerned about stabilizing output around
potential. In a sense, such a policy places more weight on the ‘long-run’ relative
to the ‘short-run.’
Let 0 ≤ λ ≤ 1 denote a parameter that indexes the degree to which a central
bank is concerned about stabilizing inflation. Then an ‘optimal’ interest rate
policy can be thought of taking the form:
Rtn = Π∗ R∗ + (1 − λ) (yt − yt∗ ) + λ (Πt − Π∗ ) . (9.9)
This equation is an example of a Taylor rule (named after John Taylor, who first
8 In terms of Figure 9.4, the central bank would in effect be keeping the economy along the
FE curve.
9.5. SUMMARY 205
proposed the equation as a description of how U.S monetary policy appeared to

be conducted; see Taylor, 1993). The Taylor rule suggests that a central bank
should increase the interest rate if as output rises above potential and/or as
inflation rises above the inflation target. How strongly a central bank should
react to either the output gap or the inflation gap will depend on the preferences
of the central bank as indexed by the parameter λ.
9.5 Summary
The New-Keynesian view accepts the neoclassical model as a reasonable way to

think about how a macroeconomy functions in the ‘long-run.’ However, New-
Keynesians argue that in the ‘short-run,’ the economy may function quite apart
from neoclassical considerations. The primary reason for this is because markets
do not work perfectly well in the short-run. In particular, there are ‘contracting
frictions’ that result in nominal rigidities, leaving the price-mechanism unable
to cope with allocating resources efficiently at every instant in response to ex-
ogenous disturbances. Furthermore, these same nominal rigidities imply that
monetary policy can (and perhaps should) influence real activity.
The New-Keynesian view also differs from the neoclassical view in terms of
the emphasis placed on which type of ‘shock’ is primarily responsible for the
business cycle. The neoclassical view emphasizes productivity shocks (and other
real disturbances). Such shocks have both ‘supply’ and ‘demand’ effects; the
latter which occur via ‘rational’ fluctuations in expectations. In contrast, the
New-Keynesian view downplays the role of productivity shocks and emphasizes
the role played by exogenous ‘demand’ shocks. Since these shocks are not viewed
as being correlated with future productivity, they are likely interpreted as being
generated largely by ‘animal spirits.’
In terms of monetary policy, an extreme neoclassical view might suggest the
abandonment of a central bank in favor of a ‘free-banking’ system. Since this is
unlikely to be a practical alternative in the foreseeable future, most neoclassical
economists would likely favor a monetary policy that targets the inflation rate
at some ‘low’ level (possibly negative). In contrast, New-Keynesian economists
are likely to favor an interest rate policy that helps stabilize output at least to
some extent, while making sure that inflation does not get wildly out of control.
Which of these two views serve as a better approximation to reality is still
a matter of debate (at least, in academia). But there is little doubt that the
New-Keynesian perspective is more widely held, especially among policymakers.
Nevertheless, it is ironic that despite these differences in perspective, many
central banks have recently veered the conduct of their monetary policy strongly
in favor of inflation-targeting—i.e., a policy that most neoclassical economists
would likely favor themselves.
9.6 References
1. Bills, Mark and Peter Klenow (2002). “Some Evidence on the Importance
of Sticky Prices,” NBER working paper #9069.
2. Caplin, Andrew and Daniel Spulber (1987). “Menu Costs and the Neu-
trality of Money,” Quarterly Journal of Economics, 102(4): 703—726.
3. Klenow, Peter and O. Krystov (2003). “State-Dependent or Time-Dependent
Pricing: Does it Matter for Recent U.S. Inflation?” NBER working paper
#11043.
4. Taylor, John B. (1993). “Discretion Versus Policy Rules in Practice,”
Carnegie-Rochester Conference Series on Public Policy, 39, pp. 195-214.
9.A. ARE NOMINAL PRICES/WAGES STICKY? 207
9.A Are Nominal Prices/Wages Sticky?

At one level, the answer to this question seems obvious: of course they are. Most
people likely have in mind the behavior of their own wage when they answer in
this way. Nominal wage rates can often remain fixed for several months on end
in some professions. Likewise, the prices of many products appear not to change
on a daily or even monthly basis (e.g., newspaper prices, taxi fares, restaurant
meals, etc.). As is so often the case, however, first impressions are not always
correct; and, if they are, they do not always lead to an obvious conclusion.
Let us first consider the evidence on product prices, which is based on the
empirical work of Bils and Klenow (2002) and Klenow and Krystov (2003):
TABLE 9.1
Duration of Prices by Category of Consumption, 1995—97
Category Median Duration Share of CPI
(months) (percent)
All Items 4.3 71.2
Goods 3.2 30.4

Services 7.8 40.8
Food 3.4 17.1

Home Furnishing 3.5 14.9
Apparel 2.8 5.3
Transportation 1.9 15.4
Medical Care 14.9 6.2
Entertainment 10.2 3.6
Other 6.4 7.2
According to Table 9.1, the median duration of price ‘stickiness’ is about 4.3
months across a broad range of product categories. Thus, it does appear to be
the case that individual product prices display a form of nominal stickiness.
But one should be careful here. Price-stickiness at the individual level need
not translate into price-level stickiness (i.e., price-stickiness at the aggregate
level). Suppose, for example, that all firms keep their prices fixed for 4 months,
but when they do change their prices, they change them significantly. One way
for the price-level to display stickiness is if a large number of firms synchronized
their price changes (for example, if all firms changed their prices at the same
time—once every 4 months). On the other hand, if firms changed their prices
in a completely unsychronized way (e.g., if everyday a small number of firms
change their prices), then the price-level may actually be flexible, despite any
inflexibility at the individual level.9
9 This result also requires that firms adopt an optimal state-contigent pricing-rule; see
It is probably fair to say, however, that reality lies somewhere between these
two extreme cases. If it does, then two other questions immediately present
themselves. The first question is where in between these two extremes? Are we
talking two, three, or possibly four months? Suppose that it is three months (i.e.,
one quarter). If the price-level is sticky for one quarter, then the second question
is whether this ‘long enough’ to have any important and lasting macroeconomic
implications? As things stand, the jury is still out on this question.
If price-level stickiness is an important feature of the economy (and it may
very well be), one is left to wonder about the source of price stickiness.10 One
popular class of theories postulates the existence of ‘menu costs,’ that make
small and frequent price changes suboptimal behavior.11 The idea behind a
fixed cost associated with changing prices seems plausible enough. But the
theory is not without its problems. in particular, Table 9.1 reveals a great deal
of variation in the degree of price-stickiness across product categories. Casual
empiricism suggests that this is the case. For example, you may have noticed
that the price of gasoline at your local gas station fluctuates on almost a daily
basis. At the same time, this same gas retailer keeps the price of motor oil fixed
for extended periods of time. Why is it so easy to change the price of gasoline
but not motor oil? Does motor oil have a larger menu cost?
Much of what I have said above applies to nominal wages as well. While some
nominal wages appear to be sticky (e.g., my university salary is adjusted once
a year), others appear to be quite flexible. For example, non-union construc-
tion workers, who often charge piece rates that adjust quickly to local demand
conditions). Furthermore, from Chapter 7 we learned that there are huge flows
of workers into and out of employment each month (roughly 5% of the employ-
ment stock). It is hard to imagine that negotiated wages remain ‘inflexible’ to
macroeconomic conditions at the time new employment relationships are being
formed. Given the large number of new relationships that are being formed each
month, it is even more difficult to imagine how the average nominal wage can
remain ‘sticky’ for any relevant length of time. These challenges to the sticky
price/wage hypothesis are the subject of ongoing research.
Caplin and Spulber (1987).

1 0 Understanding the forces that give rise to price stickiness is important for designing an
appropriate policy response.

1 1 A menu cost refers to a fixed cost; for example, the cost of printing a new menu everyday
with only very small price differences.

Chapter 10
The Demand for Fiat

Money
10.1 Introduction
Earlier, we defined money to be any object that circulated widely as a means

of payment. We also noted that the vast bulk of an economy’s money supply
is created by the private sector (i.e., chartered banks and other intermediaries).
The demand-deposit liabilities created by chartered banks are debt-instruments
that are, like most private debt instruments, ultimately backed by real assets
(e.g., land, capital, etc.). If a chartered bank should fail, for example, your
demand-deposit money represents a claim against the bank’s assets.
In most modern economies, a smaller, but still important component of the
money supply constitutes small-denomination government paper notes called
fiat money. Fiat money is defined as an intrinsically useless monetary instru-
ment that can be produced at (virtually) zero cost and is unbacked by any real
asset.
Now, let’s stop and think about this. If fiat money is intrinsically useless,
what gives it value? In other words, why is the demand for (fiat) money not
equal to zero? You can’t consume it (unlike some commodity monies). It doesn’t
represent a legal claim against anything of intrinsic value (unlike private mone-
tary instruments). Furthermore, a government can potentially print an infinite
supply of fiat money at virtually zero cost of production (there are many histor-
ical examples). Explaining why fiat money has value is not as straightforward
as one might initially imagine.
Both the Quantity Theory and the New-Keynesian model studied above
simply assume that fiat money has value (i.e., they simply assume that the
demand for fiat money is positive). In this chapter, we develop a theory that
209
210 CHAPTER 10. THE DEMAND FOR FIAT MONEY
shows under what circumstances fiat money might have value (without assuming
the result). This theory is then applied to several interesting macroeconomic
issues.
10.2 A Simple OLG Model

The basic setup here was first formulated by Samuelson (1958) in his now fa-
mous Overlapping Generations (OLG) model. Consider a world with an infinite
number of time-periods, indexed by t = 1, 2, 3, ..., ∞. The economy consists of
different types of individuals indexed by j = 0, 1, 2, ...∞. In Samuelson’s orig-
inal model, these different types are associated with different ‘generations’ of
individuals. Each generation (with the exception of the initial generation) was
viewed as living for two periods. At each point in time then, the economy was
viewed as having a set of ‘young’ and ‘old’ individuals, who may potentially
want to trade with each other. As will be shown, however, one need not in-
terpret different types literally as ‘generations’ (although, the original labelling
turns out to be convenient).
Consider a member of generation j = t, for j > 0. This person is assumed
to have preferences for two time-dated goods (c1 (t), c2 (t + 1)), which we can
represent with a utility function u(c1 (t), c2 (t + 1)). You can think of c1 as rep-
resenting consumption when ‘young’ and c2 as representing consumption when
‘old.’ There is also an ‘initial old’ generation (j = 0) that ‘lives’ for only one
period (at t = 1); this generation has preferences only for c2 (1).
Each generation has a non-storable endowment (y1 (t), 0). That is, individuals
are endowed with output when young, but have no output when old (the initial
old have no endowment). Thus, the intergenerational pattern of preferences and
endowments can be represented as follows:
Time
Generation 1 2 3 4 5 →
0 0
1 y1 (1) 0
2 y1 (2) 0
3 y1 (3) 0
↓ y1 (4) 0
Note that instead labelling a type j individual as belonging to a ‘generation,’

one can alternatively view all individuals as living at the same time but with
specialized preferences and endowments. For example, a type j = 1 individual is
endowed with a time-dated good y1 (1). This individual also has preferences for
two time-dated goods: y1 (1) and y1 (2). Clearly, this individual values his own
endowment. But he also values a good which he does not have; i.e., y1 (2). This
latter good is in the hands of individual j = 2. Note that whether individuals
lives forever or for only two periods does not matter here. What matters is that
10.2. A SIMPLE OLG MODEL 211
at any given date, there is a complete lack of double coincidence of wants. In

particular, note that individual j = 2 does not value anything that individual
j = 1 has to offer. This lack of double coincidence holds true at every date (and
would continue to hold true if individuals lived arbitrarily long lives).
10.2.1 Pareto Optimal Allocation
As in the Wicksellian model studied earlier, this economy features a lack of

double coincidence of wants. For example, the initial old generation wants to
eat, but has no endowment. The initial young generation has output which
the initial old values, but the initial old have nothing to offer in exchange.
Likewise, the initial young would like to consume something when they are
old. Since output is nonstorable, they can only acquire such output from the
second generation. However, the initial young have nothing to offer the second
generation of young. In the absence of any trade, each generation must simply
consume their endowment; this allocation is called autarky.
However, as with the Wicksellian model, this lack of double coincidence
does not imply a lack of gains from trade in a collective sense. To see this, let
us imagine that all individuals (from all ‘generations’) could get together and
agree to cooperate. Equivalently, we can think of what sort of allocation a social
planner might choose. In this cooperative, the initial young would make some
transfer to the initial old. Thus, the initial old are made better off. But what
do the initial young get in return for this sacrifice? What they get in return
is a similar transfer when they are old from the new generation of young. If
this pattern of exchanges is repeated over time, then each generation is able to
smooth their consumption by making the appropriate ‘gift’ to the old. Let me
now formalize this idea.
Let Nt denote the number of individuals belonging to generation j = t. At
any given date t then, we have Nt ‘young’ individuals and Nt−1 ’old’ individuals
who are in a position to make some sort of exchange. The total population of
traders at date t is therefore given by Nt +Nt−1 . We can let this population grow
(or shrink) at some exogenous rate n, so that Nt = nNt−1 . If n = 1, then the
population of traders remains constant over time at 2N. For simplicity, assume
that the endowment of goods is the same across generations; i.e., y1 (t) = y.
Assume that the planner wishes to treat all generations in a symmetric (or
‘fair’) manner. In the present context, this means choosing a consumption allo-
cation that does not discriminate on the basis of which generation an individual
belongs to; i.e., (c1 (t), c2 (t + 1)) = (c1 , c2 ). In other words, in a symmetric al-
location, every person will consume c1 when young and c2 when old (including
the initial old). Thus the planner chooses a consumption allocation to maximize
u(c1 , c2 ).
At each date t, the planner is constrained to make the consumption allocation
across young and old individuals by the amount of available resources. Available
output at date t is given by Nt y. Consequently, the resource constraint is given

by:
Nt c1 + Nt−1 c2 = Nt y;
or, by dividing through by Nt :
c2
c1 + = y. (10.1)
n
Notice that this resource constraint looks very much like the lifetime budget
constraint studied in earlier chapters, with n playing the role of the real interest
rate. The solution to the planner’s problem is depicted as point B in Figure
10.1.
FIGURE 10.1
Pareto Optimal Allocation in an OLG Model
c2
Resource Constraint
c2 = ny - nc1
ny
B
c2*
A
0 c1* y c1
Point A in Figure 10.1 depicts the autarkic (no trade) allocation. Clearly, all
individuals can be made better off by partaking in a system of intergenerational
trades (as suggested by the planner). The initial young are called upon to
sacrifice (y − c∗1 ) of current consumption, which is transferred to the initial
old. This sacrifice is analogous to an act of saving, except that no private debt
contract (between creditor and debtor) is involved. In particular, note that the
initial old will never pay back their ‘debt.’ This sacrificial act on the part of
the initial young is repaid not by the initial old, but by the next generation of
young; and so on down the line.
One way to imagine how trade takes place is to suppose that a central
planner forcibly takes (i.e., taxes) the initial young by the amount (y − c∗1 ) and
transfers (i.e., subsidizes) the initial old by this amount. This pattern of taxes
and subsidies is then repeated at every date. Under this interpretation, the
planner is behaving as a government that is operating a pay-as-you-go social
security system.
But there is another way to imagine how such exchanges may take place
voluntarily. What is required for this is the existence of a centralized public
record-keeping system. In particular, imagine that the young of each generation
adopt a strategy that involves making transfers to those agents who have a record
of having made similar transfers in the past. The availability of a public record-
keeping system makes individual trading histories accessible to all agents. Under
this scenario, the initial young would willingly make a transfer to the initial old.
Why is this? If they do, their sacrifice is recorded in a public data bank so that
they can be identified and rewarded by future generations. If they do not make
the sacrifice, then this too is recorded but is in this case punished by future
generations (who will withhold their transfer). By not making the sacrifice, an
individual would have to consume their autarkic allocation, leaving them worse
off.
The key thing to note here is that an optimal private trading arrangement
can exist despite the lack of double coincidence of wants and without anything
that resembles money. As Kocherlakota (1998) has stressed, money is not nec-
essary in a world with perfect public record-keeping.
10.2.2 Monetary Equilibrium

Imagine now that there is no planner and that there is no public record-keeping
technology. Since individual sacrifices cannot be recorded (and hence rewarded),
the only (non-monetary) equilibrium in this model is autarky. In such a world,
however, there is now a potential role for fiat money. Predictably, the role of
fiat money is to substitute for the missing public recording-keeping technology.
To describe a monetary equilibrium, we proceed in two steps. First, we
will describe individual decision-making under the conjecture that money has
value. Second, we will verify that such a conjecture can be consistent with a
rational expectations equilibrium. In what follows, we will restrict attention to
stationary equilibria; i.e., allocations such that (c1 (t), c2 (t + 1)) = (c1 , c2 ).
Imagine that the initial old are endowed with M units of fiat money (perhaps
created and distributed by a government). The supply of fiat money is assumed
to be fixed over time. We also assume that fiat money cannot be counterfeited.
The basic idea here is to get the initial young to sell some of their output to the
initial old in exchange for fiat money. This will turn out to be rational for the
initial young if they expect fiat money to have value in the future.
Let pt denote the price-level at date t (i.e., the amount of money it takes to
purchase one unit of output). Assume that individuals view the time-path of
the price-level as exogenous and conjecture that money is valued at each date
(so that pt < ∞). Later we will have to verify that such a conjecture is rational.
But for now, given prices, a young agent faces the following budget constraint:
pt c1 + mt = pt y;
where mt denotes ‘saving’ in the form of fiat money. Thus, given a price-level pt ,
a young individual has nominal income pt y. Some of this income can be used to
purchase consumption pt c1 and the remainder can be used to purchase money
mt (from the old). Dividing through by pt , this equation can alternatively be
written as:
c1 + q = y; (10.2)
where q ≡ mt /pt represents an individual’s real money balances (the current
purchasing power of the money they acquire).
Note that while output is nonstorable, money can be carried into the future.
Thus, in the second period of life, an individual faces the following budget
constraint:
pt+1 c2 = mt ; (10.3)
µ ¶µ ¶
pt mt
c2 = ;
pt+1 pt
c2 = Π−1 q;
where Π ≡ pt+1 /pt denotes the (gross) inflation rate.
• Exercise 10.1. Let vt = 1/pt denote the value of money (i.e., the amount
of output that can be purchased with one unit of money). Let R =
(vt+1 /vt ) denote the (gross) real rate of return on money. Show that the
real return on money is inversely related to the inflation rate Π.
By combining (10.2) and (10.3), we can derive a young individual’s lifetime

budget constraint:
c1 + Πc2 = y. (10.4)
This expression should look familiar to you; i.e., see Chapter 4. In particular,
by substituting Π = 1/R one derives c1 + R−1 c2 = y. The only difference here is
that R does not represent an interest rate on a private security; i.e., it represents
the rate of return on fiat money (i.e., the inverse of the inflation rate).
Now take a closer look at equation (10.4). Notice that the inflation rate
looks like the ‘price’ of c2 measured in units of c1 . And, indeed it is. Think of
c1 as representing a ‘non-cash’ good (i.e., a good that can be purchased without
money) and think of c2 as representing a ‘cash’ good (i.e., a good that can only
be purchased by first acquiring money). We see then that a high inflation rate
corresponds to a high price for the cash good (relative to the non-cash good).
In particular, if the inflation rate is infinite, then the price of acquiring the cash
good is infinite (it makes no sense to acquire cash today since it will have zero
purchasing power in the future).
Given some inflation rate Π, a young person seeks to maximize u(c1 , c2 )
subject to the budget constraint (10.4). The solution to this problem is a pair
of demand functions cD D
1 (y, Π) and c2 (y, Π). The demand for real money balances
D D
is then given by q (y, Π) = y − c1 (y, Π). This solution is depicted as point A
in Figure 10.2.
FIGURE 10.2
Money Demand in an OLG Model
c2
Budget Constraint
-1 -1
-1 c2 = P y - P c1
P y
A
c2D
0 c1D y c1
D
q
• Exercise 10.2. Show that the demand for real money balances may be
either an increasing or decreasing function of the inflation rate. Explain.
However, make a case that for very high rates of inflation, the demand for
money is likely to go to zero (in particular, show what happens as Π goes
to infinity).
What we have demonstrated so far is that if Π < ∞, then there is a positive

demand for fiat money. However, since we have not explained where Π comes
from, the theory is incomplete. In particular, we do not know at this stage
whether Π < ∞ is consistent with a rational expectations equilibrium.
In a competitive rational expectations equilibrium, we require the following:
1. Given some expected inflation rate Π, individuals choose q D (y, Π) opti-

mally;
2. Given the behavior of individuals, markets clear at every date; and

3. The actual inflation rate Π is consistent with expectations.
We have already demonstrated what is required for condition (1). Condition

(2) argues that at each date, the supply of money must be equal to the demand
for money. Mathematically, we can write this condition as:
M
= Nt q D (y, Π). (10.5)
pt
Since this condition must hold at every date, the following must also be true:
M
= Nt+1 q D (y, Π).
pt+1
Dividing the former by the latter, we derive:
pt+1 M Nt q D (y, Π)
= ;
pt M Nt+1 q D (y, Π)
which simplifies to:
1
Π∗ = . (10.6)
n
What this tells us is that if individuals expect an inflation rate Π∗ = n−1 ,
then there is a competitive rational expectations equilibrium in which the actual
inflation rate turns out to be Π∗ . Note that in this case, the equilibrium budget
line in Figure 10.2 corresponds precisely to the resource constraint in Figure
10.1. In other words, the resulting equilibrium is Pareto optimal.
However, this is not quite the end of the story. As it turns out, this is not the
only rational expectations equilibrium in this model. The previous equilibrium
was constructed under the assumption that individuals initially expected that
money would retain some positive value over time; i.e., that pt < ∞ for all t.
Imagine, on the other hand, that individuals initially believe that fiat money
retains no future purchasing power; i.e., that pt+1 = ∞. In this case, a rational
individual would not choose to sell valuable output for money that he expects
to be worthless; i.e., q D = 0. But from the money market clearing condition
(10.5), if q D = 0 then pt = ∞.
In other words, if everyone believes that fiat money will have no value, then in
equilibrium, this belief will become true (and hence, is consistent with a rational
expectations equilibrium). Fiat money can only have value if everyone believes
that it will. This is another example of a self-fulfilling prophesy phenomenon
that was discussed in a different context in Chapter 2 (see Section 2.6.2).
• Exercise 10.3. Explain why the value of a fully-backed monetary in-

strument is not likely to depend on a self-fulfilling prophesy. Hint: try to
see whether multiple rational expectations equilibria are possible in the
Wicksellian model studied in Chapter 8.
10.3. GOVERNMENT SPENDING AND MONETARY FINANCE 217
10.3 Government Spending and Monetary Fi-

nance
In Chapter 5, we examined how a government could finance a given expenditure
stream using either taxes or debt (the promise of future taxes). But for a gov-
ernment with control over the printing press (the supply of small denomination
paper notes), there is a third way in which it may finance its spending needs:
through the creation of new money. In this section, we study the economic impli-
cations of financing government spending requirements through money creation.
According to the Quantity Theory of Money, any expansion in the money
supply is inflationary. The evidence supporting this prediction, however, ap-
pears to be mixed; i.e., see Smith (1985). Perhaps one reason for this is because
historically, governments typically backed their money with gold (a so-called
‘gold-standard’ regime). Money, therefore, resembled a government bond, since
it reflected a promise to deliver gold at some time in the future (presumably via
higher future taxes).
During periods of fiscal crisis (often during times of war), governments would
temporarily abandon the redemption of government money for gold, promising
to restore redemption some time in the future. During these episodes, the value
of money would typically fall (i.e., the price-level would rise), and would oth-
erwise behave much like the value of a bond in partial default. The value of
money in these episodes appeared to depend on the credibility of the govern-
ment’s promise to restore the future redemption of its currency. In some cases,
such as the Confederate government during the U.S. civil war (1861-65), the
government’s promise of future redemption was ultimately reneged on (so that
Confederate notes lost all of their value by the end of the war). In other cases,
governments made good their promise of redemption (at least partially), which
often led to a rise in the value of money (a fall in the price-level).
Figure 10.3 plots the behavior of the inflation rate in the United States from
1890—2000.1 In the early part of the sample, the U.S. was on a gold standard.
This gold standard was temporarily abandoned when the U.S. entered the first
world war in 1917 (along with many of the war’s major belligerents). Notice the
large spike in inflation during and just following the war. The gold standard was
resumed for a brief period during 1925-31. Notice how the 1920s and early 1930s
were characterized by deflation (with the 1920s being a period of prosperity—the
so-called ‘roaring 20s’). During the depths of the great depression, the U.S.
again abandoned the gold standard. In 1941, the United States entered into the
second world war. Price-controls kept the inflation rate artificially low during
this period. Once the price controls were lifted (at the end of the war), inflation
spiked again. Following the second world war, the U.S. again adopted a gold
standard (via the Bretton-Woods fixed exchange rate system). Under this gold
standard, most countries settled their international balances in U.S. dollars, but
1 Source: www.j-bradford-delong.net/ Econ_Articles/ woodstock/ woodstock4.html

the U.S. government promised to redeem other central banks’ holdings of dollars
for gold at a fixed rate of $35 per ounce. However, persistent U.S. balance-of-
payments deficits (owing largely to the fiscal pressures brought on by the U.S.
war in Vietnam) steadily reduced U.S. gold reserves, reducing confidence in the
ability of the United States to redeem its currency in gold. Finally, on August
15, 1971, President Nixon announced that the United States would no longer
redeem currency for gold. Inflation remained persistently high throughout the
1970s, until it was finally brought under control in the early 1980s.
FIGURE 10.3
Thus, the figure above suggests that periods of extraordinarily high infla-
tion are linked to periods of fiscal crisis. During a fiscal crisis, the government
needs to acquire resources. If political pressures limit the government’s abil-
ity to acquire resources through direct taxes or conventional bond issues, it
may instead resort to printing small denomination paper notes. If these paper
notes are viewed as largely fiat in nature, then the extra supply of money is
likely to depress the value of money (in accordance with the Quantity Theory).
The resources that the government acquires in this manner is called seigniorage
revenue or the inflation tax.
Nowadays, most governments issue only fiat money. In most developed
economies, the inflation rate (and hence, the inflation tax) is relatively low
(at least, during peacetime). In many other countries, however, the ability to
tax or issue bonds is severely limited, so that the inflation tax constitutes a
more important source of government revenue. One question that immediately
springs to mind is whether the monopoly control of fiat money gives a govern-
ment an unlimited ability to raise seigniorage revenue. This question can be
investigated in the context of the model developed above.
10.3.1 The Inflation Tax and the Limit to Seigniorage

Imagine that there is a government that requires Gt = gNt units of output in
period t, where 0 < g < y represents the amount of government spending per
young person. To focus on money creation as a revenue device, let us abstract
from taxes and bonds. The only way in which the government can pay for its
purchases is by printing new money: Mt − Mt−1 . Let μ denote the gross rate of
money growth; i.e., Mt = μMt−1 . Thus, the amount of new money printed in
period t can be written as:
µ ¶
Mt 1
Mt − Mt−1 = Mt − = 1− Mt .
μ μ
The government’s budget constraint in every period can therefore be written as:
µ ¶
1
pt Gt = 1 − Mt .
μ
Since Gt = gNt , this can further be simplified as follows:
∙ ¸
1 Mt
g = 1− . (10.7)
μ Nt pt
Now, for a given inflation rate Π, optimal behavior on the part of households
implies a money demand function q D (y, Π); i.e., see Figure 10.2. From the
money market clearing condition, we know that the following must be true at
every date:
Mt
= Nt q D (y, Π); (10.8)
pt
Mt+1
= Nt+1 q D (y, Π).
pt+1
Dividing the former equation by the latter and rearranging terms, we derive an
expression for the equilibrium inflation rate:
μ
Π∗ = . (10.9)
n
Notice that this expression corresponds to equation (10.6) for the case of a
constant money supply; i.e., μ = 1. Note further that this expression is very
similar to the one implied by the Quantity Theory of Money; i.e., see Chapter
8 (section 8.4).
We can now combine equations (10.7), (10.8) and (10.9) to form a single
equation in one unknown variable. To do this, note that the money market
clearing condition implies that Mt /(Nt pt ) = q D (y, Π). Substituting this condi-
tion into (10.7) together with the fact that Π∗ = μ/n yields:
∙ ¸ µ ¶
1 D μ∗
g = 1− ∗ q y, . (10.10)
μ n
This equation implicitly defines the equilibrium growth rate of the money supply
μ∗ that is consistent with: individual optimization; rational expectations; and
government budget balance.
The left-hand-side of equation (10.10) represents the value of government
spending (per young person). The right-hand-side of this equation represents the
value of the resources extracted by way of an inflation tax (per young person).
The term in the square brackets represents the inflation tax rate. Notice that
for a constant money supply (μ = 1), the inflation tax rate is zero. On the other
hand, a positive growth rate in the money supply implies a positive inflation tax.
The term q D in equation (10.10) represents the inflation tax base. The greater
the willingness on the part of individuals to hold the government’s money, the
greater the ability of the government to tax them. Notice that if individuals
do not value fiat money (q D = 0), the government cannot raise any seigniorage
revenue. As with any tax revenue, the total revenue collected is the product of
the tax rate and the tax base.
Let S(μ) ≡ (1 − 1/μ)q D (y, μ/n); i.e., the amount of seigniorage revenue
collected when money grows at rate μ. We already know that no seigniorage
revenue is collected when the money supply is held constant; i.e., S(1) = 0. But
what happens when the government expands the money supply at a moderate
rate? If the demand for money reacts negatively to the higher inflation rate (a
reasonable assumption), then there are two offsetting effects on the amount of
seigniorage revenue collected. On the one hand, the higher inflation tax implies
more seigniorage revenue. On the other hand, the higher inflation rate reduces
the tax base. If the first effect dominates the second, seigniorage revenue will
rise. If the second effect dominates the first, then seigniorage revenue will fall.
For very high inflation rates, it is likely that the second effect will dominate the
first. Figure 10.4 plots the seigniorage revenue function S(μ) and the equilibria
that are possible for a given fiscal policy parameter g.
FIGURE 10.4
Seigniorage and the Laffer Curve
gmax
S(m)
1.0 mL* m
mH*
Figure 10.4 reveals that there is, in fact, a limit to a government’s ability
to raise revenue via an inflation tax. In particular, the amount of expenditure
financed by printing money cannot exceed some finite number gmax . The reason
for this is because with ever higher rates of inflation, individuals begin to econo-
mize on their real money holdings, which reduces the tax base. The shape of the
seigniorage tax function in Figure 10.4 resembles a ‘Laffer Curve’ (named after
the economist, Art Laffer). The Laffer curve suggests that a government may
actually collect more in the way of tax revenues by decreasing the tax rate (this
type of argument is often heard among the so-called ‘supply-side’ economists).
That is, while reducing the tax rate may reduce tax revenue, the resulting ex-
pansion in the tax base may more than make up for the decrease in the tax
rate.
Figure 10.4 also reveals that for some given level of government spending
g < gmax , there are two equilibria that constitute possible outcomes. One of
these equilibria is a ‘low-inflation’ regime (μ∗L ) and the other is a ‘high-inflation’
regime (μ∗H ). One can demonstrate that the utility of all individuals is higher
under the low-inflation regime.
Finally, assuming that an economy is on the left-hand-side of the Laffer curve
(the low-inflation regime), the model suggests that an expansion in government
spending financed by printing fiat money is inflationary. This prediction appears
to be broadly consistent with the historical evidence on fiscal crises.
10.3.2 The Inefficiency of Inflationary Finance
Like most taxes, the inflation tax distorts economic incentives and hence is
a source of some economic inefficiency. What exactly is the nature of this
inefficiency? Once again, we can appeal to our model to help identify the impact
of inflation on economic activity and welfare.
Consider a government that requires g units of output (per young person).
It is useful to consider first what would happen if the government chose to
finance this expenditure with a lump-sum tax τ = g. Lump-sum taxes are rare
in reality, but it serves as a useful benchmark here since lump-sum taxes are
non-distortionary.
With a lump-sum tax, the choice problem facing a young individual is to
maximize u(c1 , c2 ) subject to c1 + Πc2 = y − g. Since the money supply is
constant, we know that the equilibrium inflation rate is equal to Π∗ = 1/n.
Thus, the equilibrium budget constraint will be given by:
c2
c1 + = y − g. (10.11)
n
An increase in g serves to reduce the demand for both c1 and c2 . This is just a
pure wealth effect: the reduction in after-tax wealth reduces the demand for all
normal goods; i.e., see Chapter 3. A lump-sum tax is non-distortionary because
it does not alter the relative price of c1 and c2 . Depict this scenario as point A
in Figure 10.5.
Now imagine instead that the government chooses to finance its expendi-
tures entirely by printing money. In this case, individuals face the following
equilibrium budget constraint:
μ∗
c1 + c2 = y; (10.12)
n
where μ∗ is defined by equation (10.10). The equilibrium inflation rate here is

given by Π∗ = μ∗ /n > 1/n. The higher inflation rate distorts the relative price
of c1 and c2 (making the ‘cash’ good more expensive relative to the ‘non-cash’
good).
How does the consumption allocation (c1 , c2 ) differ across these two cases?
Let (ca1 , ca2 ) denote the allocation associated with the lump-sum tax. This allo-
cation must satisfy:
M RS(ca1 , ca2 ) = n;
ca
ca1 + 2 = y − g.
n
Let (cb1 , cb2 ) denote the consumption allocation associated with the inflation tax.
This allocation must satisfy:

n
M RS(cb1 , cb2 ) = ;
μ∗
μ∗ b
cb1 + c = y.
n 2
The first thing we can establish is that (ca1 , ca2 ) and (cb1 , cb2 ) lie on a point at
which the two budget lines cross. To see this, begin by rewriting the second
budget constraint as follows:
μ∗ b
c = y − cb1 = q b .
n 2
³ ´
μ
Now, from equation (10.10), we see that q b = μ−1 g. Substituting this ex-
pression in the equation above then yields:
µ ¶
μ∗ b μ∗
c2 = g;
n μ∗ − 1
which implies that:

cb2
g = (μ∗ − 1)
. (10.13)
n
Now, consider the second budget constraint again and manipulate it as follows:
μ∗ b cb2 cb
cb1 + c2 + = y + 2;
n n n
b
c cb
cb1 + 2 = y − (μ∗ − 1) 2 .
n n
Equation (10.13) shows that (μ∗ − 1)cb2 = g; inserting this into the equation
above yields:
cb
cb1 + 2 = y − g.
n
This establishes the fact that both (ca1 , ca2 ) and (cb1 , cb2 ) satisfy the condition
c1 + c2 /n = y − g.
So far, we have established that the two budget constraints intersect each
other. But where do they intersect? Consider Figure 10.5. Do they intersect
at a point like C (to the‘left’ of point A) or at a point like B (to the ‘right’ of
point A)? To answer this question, we can appeal to the fact that:
n
M RS(ca1 , ca2 ) = n > = M RS(cb1 , cb2 ).
μ∗
That is, the slope of the indifference curve at (cb1 , cb2 ) is ‘flatter’ than the slope
at (ca1 , ca2 ). This can only be true at a point like B.
FIGURE 10.5
Inflation Tax Distortion
c2a A
c2b
B
0 c1
a
c1
b
y-g y
Figure 10.5 reveals the distortionary impact of financing government expen-

ditures via an inflation tax. The higher inflation distorts the relative price of
‘cash’ goods (c2 ) versus ‘non-cash’ goods (c1 ), making the former more expen-
sive relative to the latter. The resulting substitution away from cash goods
lowers welfare (i.e., the indifference curve moves from point A to point B).
It is important to keep in mind here that an inflation tax is inefficient only
relative to the largely hypothetical case in which a government has access to a
lump-sum tax instrument. In reality, lump-sum taxes are often politically infea-
sible. Furthermore, in many developing countries, the bureaucratic infrastruc-
ture for collecting taxes may not be well-developed. In the developing world,
much if not most economic activity still occurs in remote rural areas. Further-
more, even in urban areas, much economic activity may occur in ‘informal’ or
underground markets, which are difficult to tax directly. In these circumstances
then, an inflation tax may prove to be a relatively efficient way to collect tax
revenue (even if it is inefficient relative to an hypothetical lump-sum tax).
• Exercise 10.4. In the model developed above, inflation does not affect
the level of real GDP since the level of production is determined exoge-
nously. However, imagine extending the model so that individuals can
divide their time between work and leisure (as in Chapter 2). Leisure, or
home-production more generally, is a good example of a ‘non-cash’ good.
How would an inflation tax influence the level of real GDP in such an
economy? Explain.
10.4. SUMMARY 225
10.4 Summary
In most economies today, governments maintain a monopoly control over the
supply of small denomination paper notes. Unlike in the past, these paper
notes are fiat in nature; i.e., they are not backed by gold or any other real asset.
Nevertheless, the availability of fiat money can improve economic efficiency by
facilitating trades that might otherwise not occur (owing to a lack of double
coincidence of wants and a lack of a public record-keeping technology). But
since fiat money is intrinsically worthless, its value depends crucially on a self-
fulfilling expectation. In particular, fiat money can only have value if people
are confident that it will be valued.
The ability to print fiat money confers to the government an additional
source of revenue called seigniorage. The ability to freely print fiat money does
not, however, imply a limitless source of revenue for a government. Seignior-
age is simply a tax, albeit an indirect tax, that reduces the purchasing power
(transferring it to the government) of all individuals who hold it. An important
limit to collecting an inflation tax is given by the willingness and ability of in-
dividuals to substitute out of activities that require the use of fiat money. In an
open economy, a further limit to seigniorage may be imposed by the willingness
and ability of individuals to substitute out of the domestic currency into other
currencies.
While an inflation tax may generate some economic inefficiency, it may nev-
ertheless constitute a relatively efficient way to collect at least some taxes. This
is particularly true of lesser-developed economies that lack an efficient method
for collecting taxes directly.
10.5 References
1. Kocherlakota, Narayana (1998). “The Technological Role of Fiat Money,”
Federal Reserve Bank of Minneapolis Quarterly Review, Summer, pp. 2—
10.
2. Samuelson, Paul A. (1958). “An Exact Consumption-Loan Model of Inter-
est with or without the Social Contrivance of Money,” Journal of Political
Economy, 66: 467—82.
3. Smith, Bruce D. (1985). “American Colonial Regimes: The Failure of the
Quantity Theory and Some Evidence in Favour of an Alternative View,”
Canadian Journal of Economics, 18: 531—65.
Chapter 11
International Monetary
Systems
11.1 Introduction
Almost every day we are presented with news concerning the behavior of the
nominal exchange rate. What is a nominal exchange rate? A nominal exchange
rate is simply the relative price of two currencies at a given point in time. For
example, the nominal exchange rate between the Canadian dollar (CDN) and
the U.S. dollar (USD) currently stands around 0.80. What this means is that
one can currently purchase $1 CDN for $0.80 USD on the foreign exchange
market. Alternatively, one can purchase 1/0.8 = 1.20 $CDN for one $USD.
Figure 11.1 plots the Canada-U.S. exchange rate since 1950 (USD per CDN).
Following the end of the second world war, many countries agreed to fix
their exchange rates in terms of USD, with the USD itself fixed to the price of
gold (one ounce of gold worth $35 US). This system of fixed exchange rates was
known as the Bretton-Woods agreement. (Canada joined the Bretton-Woods
agreement in the early 1960s). The Bretton-Woods agreement was abandoned
in the early 1970s when the United States abandoned its policy of pegging
the USD to gold. Since the abandonment of the Bretton-Woods agreement,
exchange rates have largely been left to ‘float’ (i.e., determined primarily by
market forces). Many economists who advocated the benefits of a floating ex-
change rate regime have been surprised by what many regard to be an ‘excessive’
volatility in exchange rate behavior.
227
228 CHAPTER 11. INTERNATIONAL MONETARY SYSTEMS
FIGURE 11.1
Canada - U.S. Exchange Rate
1.1
1.0
$CDN per $US
0.9
0.8
Fixed Exchange
Rate Regime
0.7
0.6
55 60 65 70 75 80 85 90 95 00 05
The perception of excessive exchange rate volatility has led many people to
question the wisdom of a floating exchange rate system. In fact, some countries
have gone so far as to abandon their national currencies in favor of a common
regional currency (e.g., the European Currency Union). Other countries, like
Argentina during the 1990s, attempted to unilaterally fix their exchange rate
relative to the USD (this experiment was abandoned in 2002). Yet other coun-
tries, such as Panama, have essentially abandoned their local currency and have
‘dollarized’ (i.e., adopted the USD).1
What are the market forces that determine the nominal exchange rate be-
tween two currencies? Is there any reason to believe that foreign exchange
rate markets are ‘different’ from other markets? Is there any reason to believe
that market-determined exchange rates are likely to display ‘excessive’ volatil-
ity driven largely by ‘speculative’ forces? Is there any rationale in adopting a
multilateral fixed exchange rate regime, like the Bretton-Woods arrangement?
Is there any rationale for a country to embark on a policy of unilaterally fixing
its exchange rate relative to some other currency? Is there any rationale for a
country to ‘dollarize’ or to arrange for a common currency among a group of
major trading partners (such as the Euro)? These are all interesting questions.
In what follows, the theory developed in the previous chapter will be brought
to bear on these questions.
1 Panamanian currency (called the Balboa) exists only in the form of coins. These coins
trade at a fixed exchange rate to the USD. All paper money in Panama consist of USD.
11.2. NOMINAL EXCHANGE RATE DETERMINATION: FREE MARKETS229
11.2 Nominal Exchange Rate Determination: Free

Markets
If all government monies were fully backed by real assets (like gold), then there
would be no reason to think of foreign exchange markets as being ‘different’
from the market for any other commodity. For example, suppose that the
Canadian dollar was made redeemable for one ounce of gold and suppose that
the U.S. dollar was made redeemable for two ounces of gold. Then logic (i.e.,
a no-arbitrage condition) suggests that one Canadian dollar should be able to
purchase 0.5 U.S. dollars.
However, government monies today are not backed in any way; i.e., they
are fiat in nature. Fiat monies are, by definition, intrinsically useless objects
created by governments. This fact alone suggests that foreign exchange markets
may indeed be ‘different’ from other types of markets (which involve either an
exchange of goods, or claims to goods). What are the market forces that de-
termine the exchange rate between two intrinsically useless objects? To answer
this question, consider the following model.
Imagine a world consisting of two countries a and b. Each country is popu-
lated by overlapping generations of individuals that live for two periods. Young
individuals have a nonstorable endowment y > 0. This endowment is the same
for young individuals across countries and consists of the same output (i.e., the
output of country a is indistinguishable from the output of country b). This lat-
ter assumption effectively fixes the real exchange rate between country a output
and country b output at unity. Such a simplification allows us to focus on the
forces that determine the nominal exchange rate.
Assume that individuals may freely trade goods internationally. In partic-
ular, what this means is that a young agent in country a may freely sell his
output to an old agent in country b; and vice-versa.
It will be useful to simplify preferences such that people care only for con-
sumption when old; i.e., U (c1 , c2 ) = u(c2 ). None of our conclusions will depend
on this assumption. The assumption simplifies matters because it implies that
young individuals will find it optimal to save their entire endowment. Since
saving in this model can only occur in the form of fiat money holdings, this
assumption essentially fixes the demand for real money balances; i.e., q D = y.
Assume that individuals in both countries have the same preferences. As well,
and again for simplicity only, assume that the population in each country is
fixed at N.
Each country has its own national money M a and M b . Assume that the
money supply in each country remains fixed over time. Let pat and pbt denote
the price-level in country a and b, respectively. Since there is free-trade in out-
put across countries, a simple no-arbitrage condition implies that the following
condition must hold:
pat = et pbt ; (11.1)
where et denotes the price of country b money measured in units of country a

money (i.e., the nominal exchange rate). Equation (11.1) is sometimes called
the Law of One Price (LOP). The LOP states that any good or asset that is
freely traded across two countries should sell at the same price (abstracting from
transportation costs, taxes, etc.), once the proper exchange rate conversion is
made. That is, suppose that you can purchase one share of General Motors on
the New York Stock Exchange for $34.45 USD and the same share for $43.34
CDN on the Toronto Stock Exchange (these are the respective closing prices
as of June 13, 2005). Then the LOP suggests that the Canada-U.S. nominal
exchange rate should be equal to et = 34.45/43.34 ≈ 0.795. (In fact, this turned
out to be the closing rate on June 13, 2005). More generally then, the LOP
suggests that:
pa
et = tb .
pt
Now, since individuals in this model have a fixed demand for real money
balances q D = y, their desired total money holdings are independent of the
rate of return on money. However, if individuals are free to hold and transact
in either money, their relative rates of return will be important for determining
the composition of an individual’s portfolio of money holdings; i.e., qaD +qbD = y.
The rate of return on each money is inversely related to the inflation rate in
each country; i.e.,
pa pb
Πa ≡ t+1 a and Πb ≡ t+1 .
pt pbt
Let us abstract from any uncertainty, so that inflation rates are deterministic.
In this case, we can appeal to a simple no-arbitrage condition that states if
individuals are to willingly hold both monies in their wealth portfolios, each
money must earn an identical rate of return; i.e.,2
Πa = Πb = Π.
Given that both monies earn the same rate of return, and given that indi-
viduals are free to hold and transact in either money, how much of each money
should individuals hold? The answer is that individuals should not care about
the composition of their money holdings; i.e., the individual demands for each
money are indeterminate under these circumstances.
In the world described above, the monies of country a and country b are
viewed as perfect substitutes. In other words, there is no independent money
market for each money. There is only a single world supply and world demand
for money; i.e., the relevant money-market clearing condition is given by:
Ma Mb ¡ ¢
+ b = 2N qaD + qbD .
pat pt
2 In the case of uncertainty, one can show that the expected rates of return on each money
must be equated with the inflation rate in each country restricted only to follow a martingale;
i.e., see Appendix 11.A.
The left-hand-side of this equation represents the total world supply of real
money balances, while the right-hand-side describes the total world demand for
real money balances. Using the fact that e = pat /pbt and qaD + qbD = y, this
equation may be rewritten as:
M a + et M b = pat 2N y. (11.2)
Equation (11.2) constitutes one equation in two unknowns: et and pat . Ob-
viously, there are infinite combinations of et and pat that satisfy this restriction.
To determine the exchange rate (and price-level), we need another equation.
However, economic theory does not deliver any further restrictions in this envi-
ronment. In other words, there are no economic fundamentals that determine
the nominal exchange rate. Any nominal exchange rate et (together with a
corresponding price-level that satisfies 11.2) is consistent with an equilibrium.
Which exchange rate actually prevails can depend entirely on ‘non-fundamental’
forces, like self-fulfilling market expectations. To put things another way, the
equilibrium nominal exchange rate between two fiat currencies is driven entirely
by market speculation.
11.2.1 Understanding Nominal Exchange Rate Indetermi-

nacy
To many people, especially those with great faith in the institution of free mar-
kets, the idea that free markets are incapable of determining the relative price of
two objects is somewhat of a puzzle. But the key to understanding this puzzle
is that fiat monies are not like any other goods or assets. Fiat currencies are
intrinsically worthless objects; it should come as no surprise that a free market
is incapable of determining a ‘fundamental’ relative price of two intrinsically
worthless objects.
Let me try to provide some intuition for this indeterminacy result by devel-
oping a series of examples. Imagine that you are sitting down with your friends
to play poker. Your host brings out the poker chips. Poker chips are intrinsically
useless objects; they are distinguished from each other only by color (red, white
and blue). The group must decide on an exchange rate system for poker chips.
Are there any fundamental market forces that determine what these exchange
rates should be?
Alright, let’s consider another example. Imagine that the Bank of Canada
prints up two types of paper notes: One note is blue (and is called a Laurier ),
while the other note is green (and is called a Queen). Imagine that the Bank of
Canada neglects to place any numbers on the notes, choosing instead to let a
free market in these notes determine the rate at which they exchange. Can you
identify any fundamental market forces that would pin down a precise exchange
rate between Lauriers and Queens?
Imagine now that there are two fiat currencies called Lincolns and Lauriers.
Imagine that Lincolns are printed by the Federal Reserve Bank of the United
States. Imagine further that both Lincolns and Lauriers are associated with the
number five (as they indeed are in reality). In many towns along the Canada-
U.S. border, merchants view Lincolns and Lauriers as perfect substitutes (i.e.,
they are willing to accept either USD or CDN as payment). If these two fiat
monies are viewed as perfect substitutes, then what, if anything, determines the
rate at which they exchange for each other?
In each of these examples, it should be clear that if different fiat monies are
viewed as perfect substitutes for each other, then it is difficult to identify any
market forces that would pin down their exchange rates.
In Canada, the nominal exchange rate between Lauriers and Queens is four-
to-one. Likewise, the nickels and dimes can be exchanged for two-to-one. How
were these nominal exchange rates determined? Is a Queen worth four times
more than a Laurier because she is prettier, or is from a royal family? And why
does the nominal exchange rate between Queens and Lauriers remain constant
over time? Are there separate and stable supplies and demands for Queens and
Lauriers?
No, of course not. The system of nominal exchange rates between different
types of Canadian money is determined by the Bank of Canada. Lauriers and
Queens exchange at four-to-one because the Bank of Canada (which prints these
notes) stands ready to exchange these two notes at the stated rate (as indicated
by the number 5 on the Laurier and the number 20 on the Queen).
Let us now reconsider equation (11.2), but in the context of a Canadian
economy that is closed to international trade. Let M a denote the supply of
Lauriers and let M b denote the supply of Queens. Thus, pat now represents
the price of output measured in Lauriers and pbt measures the price of output
measured in Queens. Suppose that the Bank of Canada sets the nominal ex-
change rate to e = 4, so that one Queen is worth four Lauriers. Then clearly,
pat = 4pbt . In other words, you have to sacrifice four times as many Lauriers (rel-
ative to Queens) to purchase the same good. Now, with the nominal exchange
rate fixed in this manner, note that condition (11.2) constitutes one equation
in the one unknown; i.e., pat . Thus, a government policy that fixes the nominal
exchange rate implies that market forces can determine a unique price-level pat
(with pbt = 0.25pat ).
Perhaps you are surprised to learn that most countries maintain a system of
fixed exchange rates for their own national monies (i.e., perhaps you’ve never
thought of nominal exchange rates in quite this way before). But the fundamen-
tal difference between Lauriers and Queens is as absent as it is between Lauriers
and Lincolns; i.e., they are just intrinsically useless bits of paper. Understand-
ing this leads to a natural question: If fixing the nominal exchange rate between
monies within a nation makes sense, why does it also not make sense to fix the
nominal exchange rate between monies across nations? In fact, why even bother
with different national currencies? Why do nations simply not agree to adopt
a single common currency?
11.2.2 A Multilateral Fixed Exchange Rate Regime

If nominal exchange rate fluctuations are driven primarily by speculation (ex-
ogenous shifts in expectations that are not based on fundamentals), then the
resulting uncertainty is likely welfare-reducing.3 In principle, nominal exchange
rate uncertainty would pose little concern if individuals held their wealth in
a diversified portfolio consisting of assets denominated in all the world’s cur-
rencies. But for various reasons, individuals do not appear to behave in this
manner. Likewise, individuals could, in principle, try to hedge foreign exchange
risk by purchasing insurance. In fact, many companies do behave in this man-
ner. But many do not and, in any case, hedging is costly. Many economists
believe that international trade would be facilitated (and welfare improved) in
the absence of nominal exchange rate risk. One way to eliminate such risk is
to enter into a multilateral agreement with other countries to fix the exchange
rate. The Bretton-Woods arrangement (1946—1971) is a classic example of such
an agreement.4
A multilateral fixed exchange rate regime sounds like a great idea—in princi-
ple. However, as you may have guessed from the collapse of the Bretton-Woods
arrangement, fixed exchange rate regimes are not without their problems. One
of the fundamental problems with maintaining a fixed exchange system is that
it requires a high degree of coordination between countries in how fiscal and
monetary policies are to be conducted. To see why this is so, let us combine
elements of the model developed above with what we have learned earlier about
the use of money as a revenue device.
Let us consider a bilateral fixed exchange rate agreement between two coun-
tries a and b. The two countries differ in their fiscal policies. In particular, the
government in country a has a ‘large’ fiscal spending program g > 0, whereas
country b has a ‘small’ fiscal spending program (that we can normalize to zero).
Imagine that both countries agree to fix the exchange rate between their two
currencies at par, so that e = 1. In this case, the LOP implies that both countries
should share the same price-level pt .
Assume that the government in country b maintains the supply of its cur-
rency at some constant level M b . Presumably, country b expects country a to
maintain its money supply at some constant level as well. Note that if country a
keeps its money supply constant, then it must finance its expenditures entirely
by taxing its own citizens. If each government behaved in this manner, then a
3 Some economists blame the speculative nature of free markets in creating excessive ex-
change rate volatility. In fact, the blame lies more with governments that insist on printing
fiat currency, which has no intrinsic value and is therefore impossible to price. If governments
were always well-behaved and if they backed their money with real assets, market forces would
have no problem in determining exchange rates on the basis of fundamentals.
4 See: http://en.wikipedia.org/ wiki/ Bretton_Woods_Conference
fixed exchange rate system should work well. But governments are not always
so well-behaved.
In particular, imagine that the government in country a is under political
pressure to keep spending high (e.g., perhaps it has a war to fight in Vietnam)
and is under political pressure to keep taxes low. Then the fiscal authority in
country a may find it irresistible to resort to the printing press to alleviate some
of these fiscal pressures. If country a chooses to finance all government expen-
ditures with money creation, then the government budget constraint implies:
pt N g = Mta − Mt−1
a
;
∙ ¸
1
= 1 − a Mta .
μt
If country a was closed to international trade (or if country b citizens were

legally prohibited from holding country a money), then the domestic money-
market clearing condition is given by:
Mta = pat N y,
(since q D = y here). This condition implies that the equilibrium domestic

inflation rate is given by μat = μa . Now, substitute the money market clearing
condition into the government budget constraint:
∙ ¸
1 Mta
g = 1− a ;
μ N pat
∙ ¸
1
= 1 − a y.
μ
Thus, the domestic inflation rate that would be required to finance the expen-
diture level g is given by:
1
μa = > 1. (11.3)
1 − yg
• Exercise 11.1. The ratio (g/y) represents the ratio of government pur-
chases to GDP. Compute the domestic inflation rate that would be neces-
sary to finance all of government spending if (g/y) = 0.20.
Let us now reconsider the calculations above under the assumption of free
trade in goods and money across the two countries (with a fixed exchange rate
e = 1). In this case, the government budget constraint in country a is given by:
pt N g = Mt − Mt−1 ;
∙ ¸
1
= 1− Mt ;
μ
where Mt = Mta + eM b denotes the total money supply across the two coun-
tries. Under free trade in goods and money, the relevant money-market clearing
condition is given by:
Mt = pt N (q a + q b );
= pt N 2y;
(since q a = q b = y here). Now, substitute this money-market clearing condition

into the government budget constraint:
∙ ¸
1 Mt
g = 1− ;
μ N pt
∙ ¸
1
= 1− 2y.
μ
In this case, the inflation rate that would be required to finance the expenditure
level g is given by:
1
μ= . (11.4)
1 − 12 yg
Now, compare equations (11.3) and (11.4). What this comparison tells us is
that country a is able to finance the same level of government spending with a
lower inflation rate under a fixed exchange rate system.
• Exercise 11.2. Redo Exercise 11.1 assuming a fixed exchange rate regime
and free trade in goods and money (i.e., using equation (11.4) instead of
equation (11.3).
What is going on here? Note that since the exchange rate is fixed at e = 1,
it follows that the price level pt is common across both countries. What this
means is that the inflation generated by country a is ‘exported’ to country b.
That is, the inflation rate calculated in equation (11.4) now applies to both
countries. Thus, under a bilateral fixed exchange rate agreement, the tax base
is effectively doubled for country a (since both countries are the same size).
The government in country a can now finance the same level of government
spending with a lower inflation rate because the tax base is so much larger. In
other words, the residents of country b end up incurring half the bill for the
government expenditures in country a.
To better understand this phenomenon, imagine that we have two monies
called Queens and Lauriers. Queen’s are worth $20 and Lauriers are worth $5.
The exchange rate is fixed by government policy at four to one. Now imagine
that the Bank of Canada starts printing large numbers of Queens, while holding
the supply of Lauriers fixed. What do you think would happen to the exchange
rate between Queens and Lauriers? The answer, of course, is nothing. What
do you think would happen to the value of money (i.e., the price-level)? One
would imagine that the price-level would rise (i.e., the value of money would
fall). However, note that because the exchange rate is fixed between Queens
and Lauriers, the expansion in the supply of Queens will reduce the value of all
money in equal proportion.
This example illustrates one of the fundamental problems associated with
maintaining a multilateral fixed exchange rate agreement. In order for such
an agreement to work well, countries must agree to restrain their monetary and
fiscal policies in an appropriate manner. Individual countries may try to ‘cheat’ a
little bit by expanding the supply of their domestic currency and thereby export
some of the inflation tax burden to other countries. If all countries behaved in
this way, the result would be a high rate of world inflation. Or an individual
country may find it difficult to restrain its monetary policy in times of fiscal
crisis. This is arguably what happened in the United States in the late 1960s
and early 1970s, as the fiscal authority struggled to meet the fiscal pressures
building from the escalation of its war in Vietnam. Under the Bretton-Woods
agreement, the United States was financing a part of its (widely unpopular)
war effort through an inflation tax that was paid in part by all members of the
Bretton-Woods agreement. Ultimately, the Bretton-Woods agreement collapsed
because of these pressures.
• Exercise 11.3. The supply of fiat money in Canada is controlled by a

single central agency (the Bank of Canada, located in Ottawa). Imagine
instead that each province of Canada was given the authority to print
Canadian dollars. What do you think might happen to the inflation rate?
Explain.
11.2.3 Speculative Attacks

The key to maintaining a fixed exchange rate system is obtain a credible com-
mitment on the part of all member governments to exchange different monies at
the stated rates. Such a commitment is necessary to defend the exchange rate
system against speculative attacks. To see why, consider the following scenario.
Imagine that Canada and the U.S. have entered into a bilateral fixed exchange
rate agreement. Now, imagine that participants in the foreign exchange (FX)
market ‘speculate’ that the Canadian dollar may depreciate. Such a speculation
may lead market participants to ‘dump’ their Canadian dollars on the FX mar-
ket (in exchange for U.S. dollars). But if the U.S. government stands ready to
print all the U.S. dollars demanded by speculators (in exchange for Canadian
dollars) at the stated rate, then the speculative attack must fail. Understand-
ing that this must be the case, there is no reason to engage in such speculative
activity.
However, many countries attempt to fix their exchange rate unilaterally, of-
ten by way of a currency board. For example, Argentina adopted a currency
board from April 1, 1991 through January 6, 2002 with the stated intent of
fixing the value of its Peso to the U.S. dollar at par. Defending one’s exchange
rate against speculative attacks is more difficult to do unilaterally than it is
via a bilateral agreement. This is because the commitment to defend the ex-
change rate must rest solely on the country imposing the peg. In particular, the
United States did not promise to help Argentina defend the Peso in the event
of a speculative attack. To defend its currency unilaterally, Argentina had to
convince FX participants that it stood ready to do whatever it took to maintain
the exchange rate. One way to do this is for the currency board to hold one U.S.
dollar in reserve for every Peso it prints (this reserve currency must ultimately
be acquired via taxation, if the Fed has no desire to hold Pesos). Alternatively,
the Argentine government must stand willing to tax its citizens to acquire the
U.S. dollars it needs to meet the demands of any speculators. More importantly,
FX participants must believe that the Argentine government would be willing
to take such an action; i.e., the stated policy must be perceived to be credible.
Figure 11.2 plots the exchange rate between the Argentine Peso and the
USD for 1995-2005. For a period of time, the Argentine currency board ap-
peared to work well, at least, in terms of maintaining a fixed rate of exchange
(par) with the USD. However, for a variety of reasons, the currency board was
compelled to abandon its peg against the USD in January 2002. Figure 11.2
shows that following this abandonment, the Argentine Peso devalued sharply
and is presently worth around $0.34 USD (about one-third of its former value).
FIGURE 11.2
Argentine Peso per USD (1995—2005)
What went wrong in Argentina? According to my Argentine friends, nothing

went wrong—what happened was perfectly normal (which is to say that every-
thing is always going wrong in Argentina). Some people place the ‘blame’ on
the U.S. dollar, which strengthened relative to most currencies over the 1990s.
Since the Peso was linked to the U.S. dollar, this had the effect of strengthening
the Peso as well, which evidently had the effect of making Argentina’s exports
uncompetitive on world markets. While there may be an element of truth to this
argument, one wonders how the U.S. economy managed to cope with the rising
value of its currency over the same period (in which the U.S. economy boomed).
Likewise, if the rising U.S. dollar made Argentine exports less competitive, what
prevented Argentine exporters from cutting their prices?
A more plausible explanation may be the following. First, the charter gov-
erning Argentina’s currency board did not require that Pesos be fully backed by
USD. Initially, as much as one-third of Pesos issued could be backed by Argen-
tine government bonds (which are simply claims to future Pesos). In the event
of a major speculative attack, the currency board would not have enough USD
reserves to defend the exchange rate. Furthermore, it would likely have been
viewed as implausible to expect the Argentine government to tax its citizens to
make up for any shortfall in reserves. Second, a combination of a weak economy
and liberal government spending led to massive budget deficits in the late 1990s.
The climbing deficit led to an increase in devaluation concerns. According to
Spiegel (2002), roughly $20 billion in capital ‘fled’ the country in 2001.5 Market
participants were clearly worried about the government’s ability to finance its
growing debt position without resorting to an inflation tax (Peso interest rates
climbed to between 40-60% at this time). In an attempt to stem the outflow
of capital, the government froze bank deposits, which precipitated a financial
crisis. Finally, the government simply gave up any pretense concerning its will-
ingness and/or ability to defend the exchange rate. Of course, this simply served
to confirm market speculation.
At the end of the day, the currency board was simply not structured in a
way that would allow it to make good on its promise to redeem Pesos for USD
at par. In the absence of full credibility, a unilateral exchange rate peg is an
inviting target for currency speculators.
• Exercise 11.4. Explain why speculating against a currency that is

pegged unilaterally to a major currency like the USD is close to a ‘no-lose’
betting situation. Hint: explain what a speculator is likely to lose/gain
in either scenario: (a) a speculative attack fails to materialize; and (b) a
speculative attack that succeeds in devaluing the currency.
5 I presume what this means is that Argentines flocked to dispose of $20 billion in Peso-
denominated assets, using the proceeds to purchase foreign (primarily U.S.) assets.
11.2.4 Currency Union
A currency union is very much like a multilateral fixed exchange rate regime.
That is, different monies with fixed nominal exchange rates essentially constitute
a single money. The only substantive difference is that in a currency union, the
control of the money supply is taken out of the hands of individual member
countries and relegated to a central authority. The central bank of the European
Currency Union (ECU), for example, is located in Frankfurt, Germany, and is
called the European Central Bank (ECB). The ECB is governed by a board of
directors, headed by a president and consisting of the board of directors and
representatives of other central banks in the ECU. These other central banks
now behave more like the regional offices of the Federal Reserve system in the
United States (i.e., they no longer exert independent influence on domestic
monetary policy).
Having a centralized monetary authority is a good way to mitigate the lack of
coordination in domestic monetary policies that may potentially afflict a multi-
lateral fixed exchange rate system. However, as the recent European experience
reveals, such a system is not free of political pressure. In particular, ECB mem-
bers often feel that the central authority neglects the ‘special’ concerns of their
respective countries. There is also the issue of how much seigniorage revenue
to collect and distribute among member states. The governments of member
countries may have an incentive to issue large amounts of nominal government
debt and then lobby the ECB for high inflation to reduce the domestic tax
burden (spreading the tax burden across member countries). The success of a
currency union depends largely on the ability of the central authority to deal
with a variety of competing political interests. This is why a currency union
within a country is likely to be more successful than a currency union consisting
of different nations (the difference, however, is only a matter of degree).
11.2.5 Dollarization
One way to eliminate nominal exchange rate risk that may exist with a major
trading partner is to simply adopt the currency of your partner. As mentioned
earlier, this is a policy that has been adopted by Panama, which has adopted
the U.S. dollar as its primary medium of exchange. Following the long slide in
the value of the Canadian dollar since the mid 1970s (see Figure 11.1), many
economists were advocating that Canada should adopt a similar policy.
One of the obvious implications of adopting the currency of foreign country
is that the domestic country loses all control of its monetary policy. Depending
on circumstances, this may be viewed as either a good or bad thing. It is
likely a good thing if the government of the domestic country cannot be trusted
to maintain a ‘sound’ monetary policy. Any loss in seigniorage revenue may be
more than offset by the gains associated with a stable currency and no exchange
rate risk. On the other hand, should the foreign government find itself in a
fiscal crisis, the value of the foreign currency may fall precipitously through an
unexpected inflation. In such an event, the domestic country would in effect
be helping the foreign government resolve its fiscal crisis (through an inflation
tax).
• Exercise 11.5. If the Argentine government had simply dollarized instead

of erecting a currency board, would a financial crisis have been averted?
Discuss.
11.3 Nominal Exchange Rate Determination:

Legal Restrictions
The previous section described a world in which individuals are free to trade
internationally and free to hold different types of fiat monies. Since fiat money
is an intrinsically useless object, one fiat money is as good as any other fiat
money; i.e., in such world, different fiat monies are likely to be viewed as perfect
substitutes for each other. But if this is true, then there are no market forces
that pin down a unique exchange rate system between different fiat monies:
the nominal exchange rate is indeterminate. This indeterminacy problem can
be resolved only by government policy; i.e., via membership in a multilateral
exchange arrangement, or via the adoption of a common currency.
The world so described appears to ring true along many dimensions. In par-
ticular, it seems capable of explaining why market-determined exchange rates
appear to display ‘excessive’ volatility. And it also explains why governments
are often eager to enter into multilateral fixed exchange rate arrangements. But
this view of the world is perhaps too extreme. In particular, if world currencies
are indeed perfect substitutes, then one would expect the currencies of differ-
ent countries to circulate widely within national borders. Casual observations
suggests, however, that national borders do, in large measure, determine cur-
rency usage. Furthermore, it is difficult (although, not impossible) to reconcile
the indeterminacy proposition with many historical episodes in which exchange
rates have floated with relative stability (see, for example, the behavior of the
Canada-U.S. exchange rate in the 1950s in Figure 11.1).
One element of reality that is missing from the model developed above is the
absence of legal restrictions on money holdings. These types of legal restrictions
are called foreign currency controls (FCCs). Foreign currency controls come in
a variety of guises. For example, chartered banks are usually required to hold
reserves of currency consisting primarily of domestic money or a restricted from
offering deposits denominated in foreign currencies.6 Many countries have ‘cap-
ital controls’ in place that restrict domestic agents from undertaking capital
account transactions with foreign agents in an attempt to keep trade ‘balanced’
6 In the late 1970s, the Bank of America wanted to offer deposits denominated in Japanese
yen, but was officially discouraged from doing so.

11.3. NOMINAL EXCHANGE RATE DETERMINATION: LEGAL RESTRICTIONS241
(i.e., to reduce a growing current account deficit). An example of such a capital

control is a restriction on the ownership of assets not located in the country of
residence. In some countries, more Draconian measures are imposed; e.g., legal
restrictions are imposed that prohibit domestic residents from holding any for-
eign money whatsoever. Such legal restrictions, whether current or anticipated,
have the effect of generating a well-defined demand for individual currencies. If
the demands for individual currencies become well-defined in this manner, then
nominal exchange rate indeterminacy may disappear.
To see how this might work, let us consider an example that constitutes
the opposite extreme of the model studied above. Let us again consider two
countries, labelled a and b. It will be helpful to generalize the analysis here to
consider different population growth rates ni and different money supply growth
rates μi for i = a, b.
Now, imagine that the governments in each country impose foreign currency
controls. Assume that this legal restriction does not prohibit international trade
(so that the young in one country may still sell output to the old of the other
country). But the legal restriction prohibits young individuals from carrying
foreign currency from one period to the next (i.e., domestic agents can only
save by accumulating domestic currency). In this case, if a young agent from
country a meets an old agent from country b, the young agent may ‘export’
output to country b in exchange for foreign currency. But the FCC restriction
requires that the young agent in possession of the foreign currency dispose of
it within the period on the foreign exchange market (in exchange for domestic
currency).
The effect of these FCCs is to create two separate money markets: one for
currency a and one for currency b. In other words, each country now has its
own money supply and demand that independently determine the value of its
fiat money; i.e.,
Mta = pat Nta y;
Mtb = pbt Ntb y.
With domestic price-levels determined in this way, the equilibrium exchange is
determined (by the LOP) as:
pat Ma Nb
et = b
= tb tb . (11.5)
pt Mt Nt
The equilibrium inflation rate in each country (the inverse of the rate of return
on fiat money) is now determined entirely by domestic considerations; i.e.,
μa μb
Πa = a
and Πb = b .
n n
From this, it follows that the time-path of the equilibrium exchange rate must
follow:
et+1 Πa μa nb
= b = b a. (11.6)
et Π μ n
Thus, in the presence of such legal restrictions, the theory predicts that if
exchange rates are allowed to float, they will be determined by the relative
supplies and demands for each currency. Equation (11.5) tells us that, holding
all else constant, an increase in the supply of country a money will lead to a
depreciation in the exchange rate (i.e., et , which measures the value of country b
money in units of country a money, rises). Equation (11.6) tells us that, holding
all else constant, an increase in the growth rate of country a money will cause it
to appreciate in value at a slower rate (and possibly depreciate, if et+1 /et < 1).
11.3.1 Fixing the Exchange Rate Unilaterally

Under a system of foreign currency controls, a country can in principle fix the
exchange rate by adopting a simple monetary policy. Equation (11.6) suggests
how this may be done. A fixed exchange rate implies that et+1 = et . This implies
that country a could fix the exchange rate simply by setting its monetary policy
to satisfy:
nb
μa = a μb .
n
Essentially, this policy suggests that country a monetary policy should follow
country b monetary policy. In other words, this model suggests that a country
can choose either to fix the exchange rate or to pursue an independent monetary,
but not both simultaneously.
11.4 Summary
Because foreign exchange markets deal with the exchange of intrinsically useless
objects (fiat currencies), there is little reason to expect a free market in interna-
tional monies to function in any well-behaved manner. In the absence of legal
restrictions, or other frictions, one fiat object has the same intrinsic value as any
other fiat object (zero). Free markets are good at pricing objects with intrinsic
value; there is no obvious way to price one fiat object relative to another. It is
too much to ask markets to do the impossible.
If governments insist on monopolizing small paper note issue with fiat money,
how should international exchange markets be organized? One possible answer
to this question is to be found in the way nations organize their internal money
markets. Most nations delegate the creation of fiat money to a centralized
institution (like a central bank). In particular, cities, provinces and states within
a nation are not free to pursue distinct seigniorage policies. The different monies
that circulate within a nation trade at fixed exchange rates (creating different
denominations) that are determined by the monetary authority. By and large,
this type of system appears to work tolerably well (most of the time) in a
relatively politically integrated structure like a nation.
11.4. SUMMARY 243
Does the same logic extend to the case of a world economy? Imagine a
world with a single currency. People travelling to foreign countries would never
have to first visit the foreign exchange booth at the airport. Firms engaged in
international trade could quote their prices (and accept payment) in terms of a
single currency. No one would ever have to worry about foreign exchange risk.
Such a world is theoretically possible. But such an arrangement would have
to overcome several severe political obstacles. First, a single world currency
would require that nations surrender their sovereignty over monetary policy
to some trusted international institution. (Given the dysfunctional nature of
the U.N. and the IMF, one may legitimately question the feasibility of this
requirement alone). This centralized authority would have to settle on a ‘one-
size-fits-all’ monetary policy and deal with the politically delicate question of
how to distribute seigniorage revenue ‘fairly.’ Given that there are significant
differences in the extent to which international governments rely on seigniorage
revenue, reaching a consensus on this matter seems highly unlikely.
If a single world currency is politically infeasible, a close ‘next-best’ alter-
native would be a multilateral fixed exchange rate arrangement, like Bretton-
Woods (sans foreign currency controls). Under this scenario, different cur-
rencies function as different denominations of the world money supply, freely
traded everywhere. Such a regime requires a high degree of coordination among
national monetary policies in order to prevent speculative attacks. More im-
portantly, it requires significant restraint on the part of national treasuries from
pressuring the local monetary authorities into ‘monetizing’ local government
debt. Under such a system, the temptation to export inflation to other coun-
tries may prove to be politically irresistible. This type of political pressure is
likely behind the collapse of every international fixed exchange rate system ever
devised (including Bretton-Woods).
If common currency and multilateral exchange rate arrangements are both
ruled out, then another alternative would be to impose foreign currency controls
and allow the market to determine the exchange rate. But while foreign cur-
rency controls eliminate the speculative dimension of exchange rate fluctuations,
exchange rates may still fluctuate owing to changes in market fundamentals. A
government could, in principle, try to fix the exchange rate in this case, but
doing so would entail a loss in sovereignty over the conduct of domestic mone-
tary policy. In any case, the imposition of legal restrictions on foreign currency
holdings is not without cost, since they hamper the conduct of international
trade (e.g., individuals are forced to make currency conversions that they would
otherwise prefer not to make).
A more dramatic policy may entail a return to the past, where governments
issued monetary instruments that were backed by gold. In general, governments
might also issue money that is backed by other real assets (like domestic real
estate). Under this scenario, government money would presumably trade much
like any private security. The value of government money would depend on
both the value of the underlying asset backing the money and the government’s
willingness and/or ability to make good on its promises. The relative price of
national monies would then depend on the market’s perception of the relative
credibility of competing governments. Governments typically do not like to issue
money backed in this manner, since it restricts their ability to extract seigniorage
revenue and otherwise conduct monetary policy in a ‘flexible’ manner.
But perhaps the ultimate solution may entail removing the government
monopoly on paper money. By many accounts, historical episodes in which pri-
vate banks issued (fully-backed) money appeared to work reasonably well (e.g.,
the so-called U.S. ‘free-banking’ era of 1836-63). Despite problems of counter-
feiting (which are obviously present with government paper as well) and despite
the coexistence of hundreds of different bank monies, these monies generally
traded more often than not at relatively stable fixed exchange rates.7 Such a
regime, however, severely limits the ability of governments to collect seigniorage
revenue. It is no coincidence that the U.S. ‘free-banking’ system was legislated
out of existence during a period of severe fiscal crisis (the U.S. civil war).
So there you have it. Given the political landscape, it appears that no
monetary system is perfect. Each system entails a particular set of costs and
benefits that continue to be debated to this day.
11.5 References
1. Champ, Bruce and Scott Freeman (2001). Modeling Monetary Economies,
2nd Edition, Cambridge University Press, Cambridge, U.K.
2. King, Robert, Neil Wallace, and Warren E. Weber (1992). “Nonfunda-
mental Uncertainty and Exchange Rates,” Journal of International Eco-
nomics, 32: 83—108.
3. Manueli, Rodolfo E. and James Peck (1990). “Exchange Rate Volatility
in an Equilibrium Asset Pricing Model,” International Economic Review,
31(3): 559—574.
4. Roubini, Nouriel, Giancarlo Corsetti, and Paolo A. Pesenti (1998). “Paper
Tigers? A Model of the Asian Crisis,” Manuscript.
5. Spiegel, Mark (2002). “Argentina’s Currency Crisis: Lessons for Asia,”
www.frbsf.org/ publications/ economics/ letter/ 2002/ el2002-25.html
7 The episodes in which some banknotes traded at heavy discount were often directly re-
lated to state-specific fiscal crises and legal restrictions that forced state banks to hold large
quantities of state bonds.
11.A. NOMINAL EXCHANGE RATE INDETERMINACY AND SUNSPOTS245
11.A Nominal Exchange Rate Indeterminacy and

Sunspots
The indeterminacy of nominal exchange rates opens the door for multiple ratio-
nal expectations equilibria (self-fulfilling prophesies). This appendix formalizes
the restrictions placed on exchange rate behavior implied by our model; see also
Manuelli and Peck (1990).
Consider two countries a and b as described in the text. Individuals have
preferences given by Et u(c2 (t + 1)), where Et denotes an expectations operator.
Note that there is no fundamental risk in this economy. But there may be
nonfundamental risk owing to fluctuations in the exchange rate.
i
Let Rt+1 denote the (gross) rate of return on currency i = a, b (i.e., the
inverse of the inflation rate). Let qti denote the real money balances held of
currency i by an individual. Then an individual faces the following set of budget
constraints:
qta + qtb = y;
a
c2 (t + 1) = Rt+1 qta + Rt+1
b
qtb .
Substitute these constraints into the utility function. The individual’s choice
problem can then be stated as:
¡£ a b
¤ a b
¢
max
a
Et u Rt+1 − Rt+1 qt + Rt+1 y .
qt
A necessary (and sufficient) condition for an optimal choice of qta is given by:
£ a b
¤ 0
Et Rt+1 − Rt+1 u (c2 (t + 1)) = 0.
Since the marginal utility of consumption is assumed to be positive, the condi-

tion above implies: £ a ¤
b
Et Rt+1 − Rt+1 = 0.
Let et = pat /pbt denote the nominal exchange rate. Then Rt+1 a
= pat /pat+1
b b b b a b a
and Rt+1 = pt /pt+1 . Hence, (et+1 /et ) = Rt+1 /Rt+1 or Rt+1 = (et+1 /et )Rt+1 .
Substitute this latter condition into the previous equation, so that:
∙ µ ¶¸
et+1 a
Et 1 − Rt+1 = 0.
et
a
Since Rt+1 > 0, this condition implies:
Et et+1 = et .
This condition exhausts the restrictions placed on exchange rate behavior by

the theory. What the condition tells us is that the nominal exchange rate can
be stochastic, but that the stochastic process must follow a Martingale. In other
words, the best forecast for the future exchange rate et+1 is given by the current
(indeterminate) exchange rate et . A special case is given by a deterministic
exchange rate; i.e., et+1 = et . But many other outcomes are possible so that
the equilibrium exchange rate may fluctuate even in the absence of any intrinsic
uncertainty (i.e., no fundamental risk).
Note that, in equilibrium, qta and qtb represent the average real money hold-
ings of individuals. These demands can fluctuate with the appearance of ‘sunspots.’
For example, if individuals (for some unexplained reason) feel like ‘dumping’
currency a, then qta will fall. Of course, since qta + qtb = y, such behavior im-
plies a corresponding increase in the demand for currency b. If individuals are
risk-averse (i.e., if u00 < 0), then individuals would want to hedge themselves
against any risk induced by sunspot movements in the exchange rate. One way
to do this is for all individuals to hold the average quantities qta and qtb in their
portfolios. In this way, any depreciation in currency a is exactly offset by an
appreciation in currency b. However, if individuals find it costly to hedge in
this manner, then sunspot uncertainty will induce ‘unnecessary’ variability in
individual consumptions, leading to a reduction in economic welfare.
11.B. INTERNATIONAL CURRENCY TRADERS 247
11.B International Currency Traders

In the model of exchange rate indeterminacy developed in the text, it was as-
sumed that all individuals view different fiat currencies as perfect substitutes.
In fact, all that is required for the indeterminacy result is that some group of
individuals view fiat currencies as perfect substitutes. In reality, this some group
of individuals can be thought of as large multinational firms that readily hold
assets denominated in either USD, Euros, or Yen (for example). In this case,
indeterminacy will prevail even if the domestic residents of (say) the United
States and Japan each prefer (or are forced by legal restriction) to hold assets
denominated in their national currency.
This idea has been formalized by King, Wallace and Weber (1992). To see
how this might work, consider extending our model to include three types of
individuals A, B, and C, with each type consisting of a fixed population N.
Think of type A individuals as Americans living in the U.S. (country a) and
type B individuals as Japanese living in Japan (country b). Type C individuals
are ‘international’ citizens living in some other location (perhaps a remote island
in the Bahamas).
Assume that foreign currency controls force domestic residents to hold do-
mestic currency only. International citizens, however, are free to hold either
currency. Let qti denote the real money balances held by international citizens
in the form of i = a, b currency. Note that q a + q b = y. Then the money-market
clearing conditions are given by:
M a = pat N (y + qta );
M b = pbt N (y + qtb ).
The nominal exchange rate in this case is given by:

µ ¶ µ ¶
pa M a y + qtb M a 2y − qta
et = tb = = .
pt M b y + qta M b y + qta
This condition constitutes one equation in the two unknowns: et and qta . Hence,
the exchange rate is indeterminate and may therefore fluctuate solely on the
‘whim’ of international currency traders (i.e., via their choice of qta ). If interna-
tional currency traders are well-hedged (or if they are risk-neutral), exchange
rate volatility does not matter to them. But any exchange rate volatility will
be welfare-reducing for the domestic residents of countries a and b.
11.C The Asian Financial Crisis
Perhaps you’ve heard of the so-called Asian Tigers. This term was originally
applied to the economies of Hong Kong, South Korea, Singapore and Taiwan,
all of which displayed dramatic rates of economic growth from the early 1960s
to the 1990s. In the 1990s, other southeast Asian economies began to grow very
rapidly as well; in particular, Thailand, Malaysia, Indonesia and the Philippines.
These ‘emerging markets’ were subsequently added to the list of Asian Tiger
economies. In 1997, this impressive growth performance came to a sudden end
in what has subsequently been called the Asian Financial Crisis. What was this
all about?
Throughout the early 1990s, many small southeast Asian economies at-
tracted huge amounts of foreign capital, leading to huge net capital inflows
or, equivalently, to huge current account deficits. In other words, these Asian
economies were borrowing resources from the rest of the world. Most of these
resources were used to finance domestic capital expenditure. As we learned in
Chapters 4 and 6, a growing current account deficit may signal the strength of
an economy’s future prospects. Foreign investors were forecasting high future
returns on the capital being constructed in this part of the world. This ‘opti-
mism’ is what fuelled much of the growth domestic capital expenditure, capital
inflows, and general growth in these economies. Evidently, this optimistic out-
look turned out (after the fact) to be misplaced.
What went wrong? One possible is that nothing went ‘wrong’ necessarily.
After all, rational forecasts can (and often do) turn out to be incorrect (after
the fact). Perhaps what happened was a growing realization among foreign
investors that the high returns they were expecting were not likely to be realized.
Investors who realized this early on pulled out (liquidating their foreign asset
holdings). As this realization spread throughout the world, the initial trickle in
capital outflows exploded into a flood. Things like this happen in the process
of economic development.
Of course, there are those who claim that the ‘optimism’ displayed by the
parties involved was ‘excessive’ or ‘speculative;’ and that these types of booms
and crashes are what one should expect from a free market. There is another
view, however, that directs the blame toward domestic government policies; e.g.,
see (Roubini, Corsetti and Pesenti, 1998). For example, if a government stands
ready to bailout domestic losers (bad capital projects), then ‘overinvestment’
may be the result as private investors natural downplay the downside risk in
any capital investment. To the extent that foreign creditors are willing to lend
to domestic agents against future bail-out revenue from the government, unprof-
itable projects and cash shortfalls are refinanced through external borrowing.
While public deficits need not be high before a crisis, the eventual refusal of
foreign creditors to refinance the country’s cumulative losses forces the govern-
ment to step in and guarantee the outstanding stock of external liabilities. To
satisfy solvency, the government must then undertake appropriate domestic fis-
11.C. THE ASIAN FINANCIAL CRISIS 249
cal reforms, possibly involving recourse to seigniorage revenues. Expectations

of inflationary financing thus cause a collapse of the currency and anticipate the
event of a financial crisis.
There is also evidence that government corruption may have played a sig-
nificant role. For example, a domestic government may borrow money from
foreigners with the stated intent of constructing domestic capital infrastruc-
ture. But a significant fraction of these resources may simply be ‘consumed’
by government officials (and their friends). For example, in 2001 Prime Min-
ister Thaksin (of Thailand) was indicted for concealing huge assets when he
was Deputy Prime Minister in 1997. Evidently, Mr. Thaksin did not dispute
the charge. Instead, he said that the tax rules and regulations were ‘confusing’
and that he made an ‘honest mistake’ in concealing millions of dollars assets,
manipulating stocks and evading taxes.8 As we saw during the recent Enron
scandal, the market reacts quickly and ruthlessly when it gets a whiff of financial
shenanigans.9
The Asian crisis began in 1997 with a huge speculative attack on the Thai
currency (called the Baht). Prior to 1997, the Thai government had unilater-
ally pegged their currency at around 25 Baht per USD. Many commentators
have blamed this speculative attack for precipitating the Asian crisis. A more
plausible explanation, however, is that the speculative attack was more of a
symptom than a cause of the crisis (which was more deeply rooted in the nature
of government policy).
Thai Baht per USD
8 See: www.pacom.mil/ publications/ apeu02/ 24Thailand11f.doc.

9 For more on the Enron fiasco, see: www.washingtonpost.com/ wp-dyn/ business/ spe-
cials/ energy/ enron/
In any case, financial crisis or not, our theory suggests that the Thai gov-
ernment could have maintained its fixed exchange rate policy and prevented
a speculative attack on its currency if it had either: (1) maintained sufficient
USD reserves; or (2) been willing to tax its citizens to raise the necessary USD
reserves. Evidently, as the Thai economy showed signs of weakening in 1997,
currency speculators believed that neither of these conditions held (and in fact,
they did not).
Would the crisis in Thailand have been averted if the government had main-
tained a stable exchange rate? It is highly doubtful that this would have been
the case. If the crisis was indeed rooted in the fact that many bad investments
were made (the result of either bad decisions or corruption), then the contrac-
tion in capital spending (and the corresponding capital outflows) would have
occurred whether the exchange rate was fixed or not. But this is just one man’s
opinion.
Chapter 12
Money, Capital and

Banking
12.1 Introduction
An almost universal feature of most economies is the coexistence of ‘base’ and
‘broad’ money instruments. In modern economies, the monetary base consists
of small denomination government paper notes, while broad money consists
of electronic book-entry credits created by the banking system redeemable in
base money. In earlier historical episodes, the monetary base often consisted
of specie (gold or silver coins) with broad money consisting of privately-issued
banknotes redeemable in base money. In this chapter, we consider a set of simple
models designed to help us think about the determinants of such monetary
arrangements.
12.2 A Model with Money and Capital

Consider a model economy consisting of overlapping generations of individuals
that live for two periods. The population of young individuals at date t ≥
1 is given by Nt and the population grows at some exogenous rate n > 0;
i.e., Nt = nNt−1 . There is also a population N0 of individuals we call the
‘initial old’ (who live for one period only). To simplify, we focus on stationary
allocations and assume that individuals care only about consumption when old;
i.e., U (c1 , c2 ) = c2 .
As before, assume that each young person has an endowment y > 0. Unlike
our earlier OLG model, however, assume that output can be stored over time
in the form of capital. In particular, k units of capital expenditure at date t
251
252 CHAPTER 12. MONEY, CAPITAL AND BANKING
yields zf (k) units of output at date t + 1, where f is increasing and strictly

concave in k. Assume (for simplicity) that capital depreciates fully after its use
in production. Note that zf 0 (k) represents the marginal product of (future)
capital. From Chapter 6, we know that zf 0 (k) will (in equilibrium) be equal to
the (gross) real rate of interest.
It will be useful to consider first how this economy functions without money.
The equilibrium, in this case, is simple to describe. In particular, since young
individuals care only for future consumption, they will save their entire endow-
ment in the form of capital spending; i.e., k = y. In this way, the young end up
consuming c2 = zf (y). The economy’s GDP at any given date t is given by:
Yt = Nt y + Nt−1 zf (y).
Let us now introduce money into this economy. Assume that there is a
supply of fiat money Mt that is initially (i.e., as of date 1) in the hands of
the initial old. The money supply grows at an exogenous rate μ ≥ 1 so that
Mt = μMt−1 . Assume that new money is used to finance government purchases.
Let Π denote the (gross) rate of inflation, so that Π−1 represents the (gross)
real return on fiat money. From Chapter 10, we know that in an equilibrium
where fiat money is valued, its rate of equilibrium rate of return will be given
by Π−1 = n/μ.
A young individual now faces a portfolio choice problem. That is, there are
now two ways in which to save for future consumption: money and capital.
Let q denote the real money balances acquired by a young individual (from the
existing old generation). The portfolio choice is restricted to satisfy q + k = y.
A simple no-arbitrage condition implies that both money and capital must earn
the same rate of return (if both assets are to be willingly held). Therefore, the
equilibrium level of capital spending must satisfy:
n
zf 0 (k ∗ ) = . (12.1)
μ
This equilibrium is displayed in Figure 12.1.

12.2. A MODEL WITH MONEY AND CAPITAL 253
FIGURE 12.1
Coexistence of Money and Capital
Rates of
Return
B
n/m
A
zf’(y)
zf’(k)
0 k* y k
Point A in Figure 12.1 displays the equilibrium without money. In this sce-
nario, the level of capital investment is ‘high’ so that the return to capital is
‘low’ (recall that we are assuming a diminishing marginal product of capital).
If n/μ > zf 0 (y), then young individuals are willing to divert some of their sav-
ings away from capital into money. As capital spending declines, the marginal
product of capital rises until the return on capital is equated to the return on
money (point B).
• Exercise 12.1. Consider Figure 12.1. Explain why the welfare of all
individuals (including the initial old) is higher at point B relative to point
A. Explain why this is so despite the fact that real GDP is lower at an
equilibrium associated with point B.
• Exercise 12.2. Use the model developed above to explain the likely
economic consequences of a decline in z. Hint: recall that z here has the
interpretation of being the current period forecast of future productivity.
In particular, emphasize the likely impact of this ‘bad news’ shock on
capital spending, the demand for money, and future GDP.
12.2.1 The Tobin Effect

Equation (12.1) suggests that while monetary policy may be neutral, it is un-
likely to be superneutral.1 Consider, for example, an exogenous (permanent)
increase in the money growth rate μ. In this model, such a policy has the effect
of increasing the expected and actual rate of inflation. Since the real rate of
return on money is inversely related to the inflation rate, the expected return on
money falls. If the return on money falls, equation (12.1) suggests that individ-
uals will substitute out of money and into capital (i.e., rebalance their wealth
portfolios) to a point at which all assets again earn the same rate of return (see
also Figure 12.1). Since the real GDP in this economy is given by:
Yt = Nt y + Nt−1 zf (kt−1 ),
it follows that such a ‘loosening’ of monetary policy has the effect of expanding
the future GDP (as the expansion in current capital spending adds to the future
capital stock). The substitution of private capital for fiat money in reaction to
an anticipated inflation is called the Tobin effect (Tobin, 1965).
The Tobin effect appears to present policymakers with a policy tool that
may be used to ‘stimulate’ the economy during a period of economic recession
or stagnation. In fact, some economists have advocated such a policy for Japan,
which struggled throughout the 1990s with low economic growth and low in-
flation (and even deflation). In a deflationary environment, the rate of return
on money is high, making capital investment relatively unattractive. For this
reason, many people view deflation as undesirable leading them to advocate a
policy geared toward increasing the inflation rate.
The logic underpinning the Tobin effect is compelling enough, but a few
caveats are in order. First of all, it is important not to confuse GDP with
economic welfare. An inflation-induced expansion of the capital stock (and
GDP) in our model unambiguously reduces the welfare of all individuals. In
particular, a very high inflation would move the economy from point B to point
A in Figure 12.1 (see exercise 12.1). One can, in fact, show that the ‘optimal’
money growth rate in this model is zero (achieved by setting μ = 1), which (for
n > 1) implies that deflation is optimal.2
There are also some practical difficulties associated with exploiting the Tobin
effect in reality. The first of these is that the stock of fiat money is typically
tiny relative to the size of the stock of capital. Thus, while one may accept the
logic of the Tobin effect, one may legitimately question whether the effect can be
quantitatively important (probably not). The second problem is that while our
model features a clear link between money growth and inflation expectations,
1 That is, note that capital spending (and other real variables) does not depend on the
money stock Mt ; but does depend on the money growth rate μ.

2 Few people appear to take seriously the notion that deflation is optimal. This view has
largely been shaped by the experience of the Great Depression. However, there are many
(earlier) historical episodes in which booms were associated with deflations. These episodes
appear to have been erased from society’s collective memory bank.
12.3. BANKING 255
in reality this link appears to be not so tight. In Japan, for example, inflation
expectations appear to remain low even today despite several years of rapidly
growing government money and debt.3
12.3 Banking
In the model developed above, fiat money and physical capital are viewed as
perfect substitutes; i.e., each asset serves the same purpose and earns the same
rate of return. In some sense, physical capital in this model is a type of ‘private
money’ that competes with government fiat money. In the model, this private
money can be thought of as privately-issued notes representing claims against
capital (e.g., corporate bonds). In equilibrium, individuals are indifferent be-
tween getting paid in government or private paper.
In reality, most privately-issued debt instruments are not widely used as a
means of payment. An important exception to this general rule are the liabilities
issued by banks; sometimes called demand-deposit liabilities. If you have a bank
account, then most your money (not wealth) is likely held in the form of this
‘bankmoney’ (electronic credits in a checkable account). Every time you use
your debit card or write a check, you are in effect making a payment with
bankmoney (i.e., the banking system simply debits your account electronically
and makes corresponding credit entries to the accounts of merchants—no paper
money is involved in such transactions).
But we do not use bankmoney for all of our transactions. For some transac-
tions, we find it convenient to use government money (cash). Few of us actually
get paid in cash; our employers pay us in bankmoney (i.e., by writing a check or
making a direct transfer to our bank account). When we need cash, we can visit
a bank or ATM and make a withdrawal. Note that our bankmoney constitutes
a demandable liability of the bank. That is, we can visit an ATM at any time
and demand the redemption of our bankmoney for cash (at par value).
Several questions may be popping to mind here. How are we to understand
the coexistence of fiat money and private money? Why is private money almost
always made redeemable on demand for cash (i.e., either government fiat or
historically in the form of specie)? Are banks free to ‘print’ all the bankmoney
they want? What is the function of banks—what do they do? Are they simply
repositories for cash, or do they serve some other function? What might happen
if all depositors wanted to withdraw cash from the banking system at the same
time? To help organize our thinking on these matters, let us develop a simple
model.
3 One possible explanation for this is that the Japanese are expecting the government to
pay back the debt out of direct tax revenue instead of seigniorage.
12.3.1 A Simple Model
The formal model associated with this section can be found in Andolfatto (200*).
In what follows here, we will make do with an informal description. The econ-
omy is similar to that described above. Imagine, however, that individuals
populate two ‘spatially separated’ locations, labelled A and B. Each location
is identical in terms of population, technology and endowments. Assume that
individuals living in a location do not accept private liabilities issued by agents
living in the ‘foreign’ location. There are several ways in which to interpret
this restriction. One interpretation is that local residents do not trust ‘foreign’
paper, perhaps because it is difficult to detect counterfeits (unlike locally issued
money or government cash). Another interpretation is that the two locations
are not connected electronically, so that debit card transactions are not feasible
for ‘tourists’ visiting the foreign location.
Young individuals have an endowment y and have access to an investment
technology that takes k units of output today and returns zk units of output in
the future; i.e., assume constant returns to scale so that f (k) = k. In this case,
the (gross) return to capital spending is given by z. Assume that z > n and that
μ = 1 (constant supply of fiat money). In this case, capital dominates money in
rate of return (as is typically the case in reality). But if capital (private money)
dominates fiat money, why is the latter held at all? In order to be valued, fiat
money cannot be a perfect substitute for capital—it needs to fulfill some other
purpose.
This other purpose is generated in the following way. Young individuals
must make a portfolio decision (money versus capital). Imagine that after this
decision is made, a fraction 0 < π < 1 of young individuals at each location
are exogenously transported to the foreign location. Assume that they cannot
take their capital with them. They could try to take paper notes representing
claims to the capital they left behind, but by assumption, such claims are not
‘recognized’ in the ‘foreign’ location. How then are these ‘visiting’ individuals
to purchase the consumption they desire when old? One way would be to use
a payment instrument that is widely recognizable, like government fiat or gold.
In this sense then, it is useful to think of π as an the probability of experiencing
an individual ‘liquidity’ shock (i.e., of encountering a situation where merchants
will only accept cash).
Since young individuals are uncertain about whether they will need cash in
a future transaction, they will want to hedge their bets (if they are risk-averse)
by holding some capital and some cash in their portfolio. Hedging in this way
is better than not hedging at all, but it is still inefficient. Since there is no
aggregate uncertainty, it would make sense for young individuals to pool their
risk. One way of doing this is through a bank that operates in the following
way.
Imagine that young individuals ‘deposit’ their endowment (real labor earn-
ings) with a bank. In return, the bank offers each depositor an interest-bearing
12.3. BANKING 257
account that is redeemable (on demand) for government cash. If individuals do

not make an early withdrawal, they earn a real interest rate equal to z (and
consume locally). If they make an early withdrawal (because the experience the
liquidity shock), they earn a real return equal to n < z (and consume in the
foreign location).
A competitive bank would structure its balance sheet in the following way.
It would take the deposits made to the bank and use some of the deposits to
acquire cash (from the existing old agents). How much cash a bank should hold
in reserve depends on how much cash is forecasted to be withdrawn. In our
model, there is no aggregate uncertainty so that the bank can easily forecast
that a known fraction π of its depositors will want to make an early withdrawal.
Any resources that are not used up in the form of cash reserves can then be used
to finance capital spending (e.g., making loans to entrepreneurs or acquiring the
capital directly). The bank can then use the return on its loan portfolio to pay
the interest its own liabilities (i.e., the interest on its deposit accounts).
A few observations are in order. First, note that the balance sheet of our
model bank resembles the balance sheet of real banks. That is, the asset side
consists of loans and cash reserves. The liability side consists of demandable
debt. This demandable debt earns a higher return than government cash and is
used widely as a form of payment. But not all places accept bankmoney (checks
or debit cards). For this reason, banks stock their ATMs with government cash
and allow their depositors to withdraw this cash on demand.
Second, note that banks are not free to create unbacked money (unlike the
government). A well-run bank will be ‘well-capitalized’ in the sense that it
should have assets of sufficient value to back up its outstanding liabilities. Note,
however, this does not mean a bank will hold all of its assets in the form of
government cash (which would correspond to a 100% reserve requirement). By
holding less than 100% reserves, banks are able to facilitate the financing of
productive capital projects (that might not otherwise get financed). Of course,
banks can be subject to fraudulent activity; for example, if a loans officer grants
a loan to a friend (who has no intention of repaying) and tries to pass it off
as an ‘investment.’ But fraud is illegal and is, in any case, not specific to the
banking industry.
Finally, there is an issue of whether banks are in some sense ‘fragile’ financial
structures that may be subject to ‘bank runs’ (where everyone rushes to the bank
to withdraw cash). The reason people worry about this is owing to the structure
of a bank’s balance sheet. In particular, its assets are relatively ‘long-term’ and
‘illiquid,’ while its liabilities constitute a form of very short-term debt (i.e.,
demandable debt). Of course, I argued above that this balance sheet structure
is no accident; i.e., this is the business of banking. But the question remains
as to whether such a structure is susceptible to collapse that is generated, for
example, by a self-fulfilling prophesy. What if, for example, everyone suddenly
perceives a bank to be insolvent. Then they will ‘run’ to the bank to withdraw
their cash. If everyone runs, there will not be enough cash to satisfy depositors.
The bank will then be forced to liquidate its assets quickly at firesale prices,
possibly rendering the bank insolvent and confirming the initial expectation.
Certainly, there have been historical episodes that seem to fit the description
above. It is not clear, however, whether such episodes were the product of
banking per se or of government restrictions on bank behavior. For example,
branch banking was for many years prohibited in the United States but not
in Canada, leading to thousands of smaller banks in the U.S. and only a few
larger banks in Canada. It is well-known that many banks failed in the U.S.
during the Great Depression whereas none did in Canada. In another example,
many of the state banks of the so-called U.S. ‘free-banking’ era were forced to
hold as assets state bonds of questionable quality. When state governments fell
into fiscal crisis, banks that held government bonds naturally did too. Both of
these examples are often cited as evidence of banking ‘instability.’ However, in
both cases, legal restrictions were in place that prevented banks from creating
a well-diversified asset portfolio.
12.3.2 Interpreting Money Supply Fluctuations

As I have remarked before, much of an economy’s money supply is in the form
of demand deposit liabilities created by private banks. These liabilities are con-
vertible on demand (and at par) for government cash. The fact that bankmoney
is convertible at par with government cash effectively fixes the nominal exchange
rate between bankmoney and fiat money. One popular definition of an econ-
omy’s total supply of money is therefore given by the sum of government cash
(in circulation) and the demandable liabilities created by chartered banks. This
definition of money is called M 1. Broader measures of money may include other
types of private securities, including savings accounts, term deposits, money
market mutual fund balances, and so on.
Most of the fluctuations in an economy’s money supply stems from fluctua-
tions in bankmoney, or the so-called ‘money-multiplier.’ The money multiplier
is defined as the total money supply divided by (essentially) the monetary base
(i.e., government cash). Fluctuations in the money multiplier (or broad money)
appear to be closely linked with fluctuations in real output. Changes in the
current money supply appear to be positively correlated with future changes
in real GDP. Why does the money supply vary in this manner? Does the ob-
served money-output correlation imply that a monetary authority stimulate the
economy with a surprise injection of cash?
To help address these questions, let us consider the model developed above
(and stated formally in the appendix). Assume that the stock of government
money remains fixed at M. Let (q ∗ , k∗ ) denote the bank’s (or banking system’s)
optimal portfolio choice. Note that this choice will depend on the model’s
parameters. The parameter I wish to emphasize here is z; i.e., the current
forecast of the future return to capital investment. Under a mild restriction on
preferences, the model implies that k∗ is an increasing function of z. In other
12.3. BANKING 259
words, capital spending today responds positively to ‘news’ of a higher expected

return on capital (note that z also corresponds to the real rate of interest in this
economy). Since q + k = y, it follows that the demand for real money balances
is a decreasing function of z. In other words, news of a higher z leads market
participants (including banks) to substitute out of cash and into capital (banks
would accomplish this by extending more loans to finance capital spending).
Now imagine that the economy is continually hit by shocks that take the
form of changes in z. What are the economic implications of such disturbances
and, in particular, how do they affect the money supply?
Let us begin with the money-market clearing condition:
Mt
= Nt qt .
pt
For simplicity, let us hold the supply of fiat money and the population fixed.
Then the equilibrium price-level will satisfy:
M
p∗t = . (12.2)
N qt∗
• Exercise 12.3. Imagine that the economy receives ‘news’ that leads
individuals to revise downward their forecast of z. What effect is such a
shock likely to have on the real interest rate and the price-level? Explain.
Now recall that the total money supply (M 1t ) is the sum cash and bankmoney.
The real value of a bank’s physical capital is given by N kt∗ (assuming that it
has N depositors). The nominal value of this bankmoney is given by p∗t N kt∗ , so
that:
M 1t = M + p∗t N kt∗ .
Substituting equation (12.2) into this latter expression, one can derive:
M
M 1t = M + N kt∗ ; (12.3)
N qt∗
∙ ¸
k∗
= 1 + ∗t M.
qt
The term in the square brackets above is the money-multiplier M 1/M. Our
model suggests that the money multiplier is positively related to the ‘deposit-
to-currency’ ratio k/q.
Now consider the empirical observation that changes in the current money
supply M 1t appear to be positively correlated with future changes in real GDP.
We can use the model developed here to interpret such a correlation. Suppose,
for example, that the economy is subject to ‘news’ shocks that lead people
to constantly revise their forecasts of z (the future return to current capital
spending). Consider, for example, a sudden increase in z. From our earlier
discussion, such a shock should lead individuals (or banks acting on their behalf)
to substitute out of cash and into capital investment. In other words, kt∗ should
increase and qt∗ should decrease. From equation (12.3), we see this reaction
will lead to an increase in the money multiplier and hence to an increase in
M 1t (even if M remains constant). Furthermore, the increase in current period
capital spending will translate (together with the increase in z, if it materializes)
into higher levels of future GDP.
Notice that while our model can replicate the observed money-output cor-
relation, the model suggests that it would be wrong to interpret the current
increase in M 1t as having ‘caused’ the future increase in real GDP. In fact, the
direction of causality is reversed here; i.e., it is the increase in (forecasted) real
GDP that ‘causes’ an increase in the current money supply. This is an example
of what economists call ‘reverse causation,’ and serves as a useful warning for
us not to assume a direction of causality simply on the basis of an observed
correlation (e.g., we would not, for example, assert that Christmas shopping
‘causes’ Christmas, even though though early-December Christmas shopping is
positively correlated with the future arrival of Christmas).
12.4 Summary
To be written (chapter is incomplete).
12.5 References
1. Andolfatto, David (2003). “Taking Intermediation Seriously: A Com-
ment,” Journal of Money, Credit and Banking, 35(6-2): 1359—1366.
2. Tobin, James (1965). “Money and Economic Growth,” Econometrica, 33:
671—84.
Part III
Economic Growth and

Development
261
Chapter 13
Early Economic
Development
13.1 Introduction
The questions of why some economies grow while others do not, or why economies
grow at all, are perhaps the most fascinating (and unresolved) issues in the
science of economics. These questions are related, but distinct. The former
question asks why less-developed economies simply do not imitate their well-
developed counterparts. The latter question asks what triggers economic devel-
opment in even relatively advanced economies. Given that our current living
standards depend on past growth rates and that our future living standards
(or those of our children) will depend on current and future growth rates, the
question of growth and development is of primary importance.
Most people would agree that the high living standards that we enjoy today
(relative to historical levels and to less developed contemporary economies) is
directly attributable to the advanced state of technology, which we can define
broadly to include basic scientific and engineering knowledge, human capital,
organizational design, and so on. Understanding this basic fact, however, is not
very helpful since it does not explain how we came to acquire this advanced
technology (and why some less developed economies simply do not imitate us).
Furthermore, it appears evident that there must be more to the story of rising
per capita living standards than just technological progress. As I will describe
in this chapter, technological progress has been with us since the beginning
of recorded history. And yet, up until the Industrial Revolution (c. 1750),
growth in per capita living standards appears to have been modest at best. It
appears that technological advances in the Pre-Industrial Revolution era man-
ifested themselves primarily in the form of population growth (i.e., growth in
GDP rather than per capita GDP).
263
264 CHAPTER 13. EARLY ECONOMIC DEVELOPMENT
In this chapter, I will take some time to outline the evidence pertaining
to technological advancements prior to the Industrial Revolution. I will then
present a theory of growth (due to Thomas Malthus). Like many so-called
growth models, however, the theory does not explain the source of technological
advancement. But the model does offer an explanation as to why technological
progress (if it occurs at all) manifests itself as population growth, instead of
growth in per capita living standards.
13.2 Technological Developments

This section is not meant to be an exhaustive survey of technological progress
throughout the ages. But a sufficient number of examples are provided that
should convince you of the remarkable technological advancements that have
occurred throughout recorded history.1 As is the case today (but to a lesser
extent), economies varied in their use of available technologies. The diffusion
(implementation) of new technologies (and ideas in general) occurred slowly (if
at all). Economies that employed the best technology often grew to be world
powers, dominating those around them. It is also interesting to note that the
centers of power (wealth and knowledge) shifted many times over the course of
history.
13.2.1 Classical Antiquity (500 B.C. - 500 A.D.)
The classical civilizations of Europe (Greek, Hellenistic, and Roman) were in

many ways more scientifically advanced than anything Europe had to offer up
to the renaissance period (c. 1450 A.D.). Important achievements of classi-
cal technology included: coinage, alphabetization, stenography and geometry.
In addition to their achievements in literature, advances were made in mathe-
matics, medicine, science, architecture, construction, and political organization.
However, in other areas, there was (from our perspective today) a distinct lack
of progress in many important areas, such as the development of mechanical
devices, chemistry, and farming.
The technological progress in the classical world (especially in Roman times)
was typically geared to the public, rather than the private, sector. The Rome
of 100 A.D. had better paved streets, sewage, water supply, and fire protection
that the capitals of Europe in 1800 A.D. Most agriculture, manufacturing, and
services were carried out by the private sector, and achievements there were
slow. The lack of progress in developing mechanical devices for commercial uses
is particularly interesting, since a great achievement of the classical world was
in recognizing fully the important elements of machinery, such as the lever, the
wedge and screw, the ratchet, the pulley, the gear and the cam. Apparently,
1 These examples are taken from Mokyr (1990).
13.2. TECHNOLOGICAL DEVELOPMENTS 265
these insights were applied mostly to war machines and clever gadgets that were
admired for their own sake but rarely put to useful purposes.
Many of the classical ideas lay dormant for centuries. For example, Hero of
Alexandria (1st century A.D.) developed a working steam engine used to open
temple doors; a coin-operated vending machine (for holy water in the temple).
Similarly, Ctesbius (3rd century A.D.), who has been called by some the Edi-
son of Alexandria, reportedly invented the hydraulic organ, metal springs, the
water clock, and the force pump. An important question is why so little of this
potential was realized and translated into economic progress. Many inventions
that could have led to major economic changes were underdeveloped, forgotten
or lost. This is especially puzzling in light of the fact that classical civilizations
were relatively literate and mobile.
13.2.2 The Middle Ages (500 A.D. - 1450 A.D.)

Early medieval Europe (sometimes referred to as the Dark Age) managed to
break through a number of technological barriers that held the Romans back.
This is all the more remarkable when one recognizes that many of the ingredients
that are commonly thought of as essential to technological progress were absent.
Especially during the Dark Ages, the economic and cultural climate in Europe
was primitive compared to the Classical period. Literacy had become rare
and the upper classes devoted themselves primarily to warfare. Commerce and
communications declined to almost nothing. The great infrastructure of the
Roman empire was left to depreciate. Law enforcement and the security of life
and property became more precarious than ever. And yet toward the end of the
Dark Ages, in the eighth and ninth centuries, European society began to show
the first signs of what was soon to become a torrent of technological creativity.
In contrast to the Classical age, these new technological developments took the
form of practical tools and ideas that reduced the daily toil and increased the
material comfort (however marginally) of the masses.
In terms of their direct contribution to aggregate output, changes in agricul-
tural technology were of primary importance as the bulk of the population was
engaged in farming. Some of the key advances included: the introduction of the
heavy plow, the wheelbarrow (both invented in China, c. 300-100 B.C.) and the
three-field system; the extensive use of water power; and the modern horse col-
lar (and horseshoe). The widespread application of these technologies allowed
medieval Europe to build an economy based on nonhuman power, in contrast to
the widespread use of slaves in Classical economies. Other important inventions
included the weight-driven mechanical clock, which has been referred to some
as the key machine of the modern industrial age, and the printing press, which
allowed books to be published on an unprecedented scale.
Medieval Western technology drew from three sources: classical antiquity,
contemporary Islamic and Asian societies, and its own original creativity. The
second source of ideas is of particular interest, since it indicates a willingness
by Europeans to shamelessly adopt the ideas of other cultures.

From about 700 A.D. - 1200 A.D., the cultural and technological center of
gravity of Europe remained to a large extent in the Islamic societies of Spain,
Northern Africa and the Middle East. The culture and technology of Islam
constituted a synthesis of Hellenistic and Roman elements, together with ideas
from central Asia, India, Africa and China. Early Islamic society collected,
compiled, and catalogued knowledge avidly. Both rich and poor alike apparently
travelled extensively and learned eagerly from other cultures. It was a society
literate beyond Europe’s wildest dreams. During this time, the Moslems knew
more about the different parts of the known world than any other civilization.
Important Moslem contributions to technology in this era include the devel-
opment of the lateen sail, tidal mills, and windmills. They were also responsible
for the introduction of paper (invented in China, c. 100 A.D.) into the Middle
East and Europe (the first paper factory was set up in Baghdad, c. 793 A.D.).
Other notable advances occurred in textile production, agriculture, and chem-
ical technology. The great strength of the early Islamic world, however, lay in
its ability and willingness to adopt existing technologies from foreign sources.
From about 1200 A.D. on, however, both innovative and imitative activity
in the Moslem world slowed down, for reasons that are still not very clear. Some
people blame the destruction of the eastern Islamic world by Mongol invasions.
Others point to political and religious factors. In any case, by about this time,
the economies of western Europe had absorbed most of what the Moslem world
had to offer.
The truly great technological powerhouse of the ancient and medieval world
was China, which maintained its technological supremacy until about 1400 A.D.
Major improvements in the cultivation of rice revolutionized Chinese agriculture.
The control of water through hydraulic engineering (dams, ditches, dikes, etc.)
allowed the drainage and irrigation of lands. The iron plow was introduced in
the sixth century B.C. Chinese agriculture learned to use new fertilizers and
chemically based pest control agents. The Chinese led the Europeans by 1500
years in the use of blast furnaces, allowing them to use cast iron and refine
wrought iron from pig iron. Other notable (but by no means exhaustive) list of
inventions include the invention of the compass, gunpowder, multistage rockets,
paper, and the most technologically advanced ships of the time.
The extent of technological development in China by 1300 A.D. was appar-
ently such that “China came within a hair’s breadth of industrializing in the
fourteenth century.” (Jones, 1981, pg. 160). And yet, industrialization did not
occur. In fact, by about 1400 A.D., technological progress in China slowed
down dramatically to the point of almost ceasing altogether and in some cases
even regressing. By the end of the Middle ages, Europe became the world’s
technological leader.
13.3. THOMAS MALTHUS 267
13.2.3 The Renaissance and Baroque Periods (1450 A.D.

- 1750 A.D.)
Europe is unlike China in that it was never politically unified. Consequently,
the centers of influence shifted over time across regions (or countries). The
Renaissance (rebirth) era (1450 A.D. - 1600 A.D.) originated in the great Italian
city states of Venice, Genoa and Florence with Spain (and to a lesser extent,
Portugal) emerging as the world’s leading power in the sixteenth century. With
Spain’s gradual decline following the defeat of the Armada (1588) at the hands
of the English, the balance of power shifted in the Baroque era (1600 A.D. -
1750 A.D.) toward England, France and Holland.
This episode in European history is known more for art and exploration than
for its technological achievements. Technological progress did occur throughout
the period, but manifested itself more in the form of sequences of improve-
ments to existing technology. Much of the growth in output were due to an
expansion in international trade, facilitated by financial market innovations like
commercial banking, as well as innovations in shipbuilding. In agriculture, the
so-called new husbandry (the introduction of new crops, stall feeding of cattle,
and the elimination of fallowing) led to major productivity gains. In energy use,
medieval techniques were improved but not revolutionized, although the slow
expansion of coal power was to have significant future ramifications. Major
improvements were made in the efficiency of blast furnaces, mining techniques
and hydraulic engineering. However, the diffusion of technology occurred very
slowly, with old techniques coexisting along side best-practice techniques for
centuries.
On the whole, the period was characterized more by its scientific achieve-
ments than its technological breakthroughs. The most famous visionary of the
Renaissance, Leonardo da Vinci, designed thousands of machines and mechani-
cal devices, including the helicopter, the retractable landing gear, the tank, and
the parachute. Most of his ideas, however, defied any practical application until
centuries later.
In the field of science, the Renaissance differed from Classical times in that
the dichotomy between thinkers and makers broke down. Many scientists made
their own instruments and contributed to the solution of practical problems
associated with their manufacture. Galileo, for example, built his own telescopes
and worked part time fixing machines. But the number of truly important
technological breakthroughs brought about by great scientists still remained
relatively small.
13.3 Thomas Malthus

Thomas Malthus (1766-1834) is probably most famous for his provocative work
entitled Essay on the Principle of Population (1798), which was directed at
William Godwin (1756-1836) whose Enquiry Concerning Political Justice (1793)

argued in favor of a more egalitarian society in order to end poverty. Godwin
was a proponent of government welfare programs like the English Poor Law of
1601, which provided direct grants to the poor financed by property taxes. On
the matter of the Poor Laws, Malthus had this to say:
“The poor-laws of England tend to depress the general condition

of the poor in these two ways. This first obvious tendency is to
increase population without increasing the food for its support. A
poor man may marry with little or no prospect of being able to
support a family in independence. They may be said therefore in
some measure to create the poor which they maintain; and as the
provisions of the country must, in consequence of the increased pop-
ulation, be distributed to every man in smaller proportions, it is
evident that the labour of those who are not supported by parish
assistance will purchase a smaller quantity of provisions than before,
and consequently, more of them must be driven to ask for support.
Secondly, the quantity of provisions consumed in workhouses upon
a part of the society, that cannot in general be considered the most
valuable part, diminishes the shares that would otherwise belong to
more worthy members; and thus in the same manner forces more to
become dependent. ...
Other circumstances being the same, it may be affirmed that coun-
tries are populous according to the quantity of human food which
they produce or can acquire, and happy according to the liberality
with which this food is divided, or the quantity which a day’s labour
will purchase. Corn countries are more populous than pasture coun-
tries, and rice countries more populous than corn countries. But
their happiness does not depend upon their being thinly or fully in-
habited, upon their poverty or their richness, their youth or their
age, but on the proportion which the population and the good bear
to each other.”
With the publication of his Essay, controversial debates swept throughout

England. To quote Malthus’ biographer, James Bonar:
“For thirty years it rained refutations. Malthus was the most abused
man of the age, put down as a man who defended smallpox, slavery
and child murder, who denounced soup kitchens, early marriage and
parish allowances; who had the impudence to marry after preaching
against the evils of a family; who thought the world so badly gov-
erned that the best actions do the most harm; who, in short, took
all romance out of life.”
The historical setting, in which Malthus brought out his work, must be
considered. The poor, especially those in the rural areas, were numerous and
were generally in a bad state. It was generally thought that the plight of the
poor was due to the landed aristocracy, that they had the government levers in
their hands and used them to advance the upper classes at the expense of the
poor.
In contrast, Malthus explained the existence of the poor in terms of two
‘unquenchable passions:’ (1) the hunger for food; and (2) the hunger for sex.
The only checks on population growth were wars, pestilence, famine, and ‘moral
restraints’ (the willingness to refrain from sex). From these hungers and checks,
Malthus reasoned that the population increases in a geometric ratio, while the
means of subsistence increases in an arithmetic ratio. The most disturbing as-
pect of his theory was the conclusion that well-intentioned programs to help the
poor would ultimately manifest themselves in the form of a greater population,
leaving per capita incomes at their subsistence levels. It was this conclusion
that ultimately led people to refer to economics as ‘the dismal science.’
13.3.1 The Malthusian Growth Model

The Malthusian ‘growth model’ can be formalized in the following way. There
are two key ingredients to his theory: (1) a technology for production of output;
and (2) a technology for the production of people. The first technology can be
expressed as an aggregate production function:
Yt = F (K, Nt ), (13.1)
where Yt denotes total real GDP, K denotes a fixed stock of capital (i.e., land),
and Nt denotes population (i.e., the workforce of peasants). The production
function F exhibits constant returns to scale in K and Nt . For example, suppose
that F is a Cobb-Douglas function so that F (K, N ) = K 1−θ N θ , where 0 < θ <
1.
Because F exhibits constant returns to scale, it follows that per capita in-
come yt ≡ Yt /Nt is an increasing function of the capital-labor ratio. Since
capital (land) is assumed to be in fixed supply, it follows that any increase in
the population will lead to a lower capital-labor ratio, and hence a lower level
of per capita output. Using our Cobb-Douglas function,
µ ¶1−θ
Yt K
yt = = ,
Nt Nt
which is clearly decreasing in Nt . The ‘hunger for food’ is captured by the

assumption that all output is consumed.
On the other hand, the total GDP is clearly an increasing function of Nt ; i.e.,
Yt = K 1−θ Ntθ . However, since land is fixed in supply, total output increases at
a decreasing rate with the size of the population. Let f (Nt ) ≡ K 1−θ Ntθ denote
total output; this production function is depicted in Figure 13.1.
FIGURE 13.1
Malthusian Production Function
Yt
f(Nt )
0
Yt
0
Slope = yt
0 Nt
0
Nt
The technology for producing people is expressed as follows. First, assume

that there is an exogenous birth rate b > 0. This assumption capture’s Malthus’
view that the rate of procreation is determined largely by noneconomic factors
(such as the passion for sex). On the other hand, the mortality rate (especially
among infants and the weaker members of society) was viewed by Malthus as
determined in part by economic factors, primarily the level of material well-
being as measured by per capita income yt . An increase in yt was thought to
lower mortality rates (e.g., better fed babies are healthier and are less likely to
die). Likewise, a decrease in yt was thought to increase mortality rates. The
dependence of the mortality rate mt on living standards yt can be expressed
with the function:
mt = m(yt ),
where m(.) is a decreasing function of yt .
Let nt denote the (net) population growth rate; i.e., nt ≡ b − mt . Then
it is clear that the population growth rate is an increasing function of living
standards; a relation that we can write as:
nt = n(yt ), (13.2)
where n(.) is an increasing function of yt . This relationship is depicted in Figure
9.2. It follows then that the total population Nt grows according to:
Nt+1 = [1 + n(yt )]Nt . (13.3)
Note that when yt = y ∗ (in Figure 13.2), the net population growth rate is equal
to zero (the birth rate is equal to the mortality rate) and the population stays
constant.
FIGURE 13.2
Population Growth Rate
nt
n( yt )
0 y* yt
13.3.2 Dynamics
The Malthusian growth model has implications for the way real per capita GDP
evolves over time, given some initial condition. The initial condition is given
by the initial size of the population N0 . For example, suppose that N0 is such
that y0 = f (N0 ) > y ∗ , where y ∗ is the ‘subsistence’ level of income depicted in
Figure 13.2. Thus, initially at least, per capita incomes are above subsistence
levels.
According to Figure 13.2, if per capita income is above the subsistence level,
then the population grows in size (the mortality rate is lower than the birth
rate); i.e., n0 > 0. Consequently, N1 > N0 . However, according to Figure 13.1,
the added population (working the same amount of land) leads to a reduction
in living standards (the average product of labor falls); i.e., y1 < y0 .
Since living standards are lower in period 1, Figure 13.2 tells us that mor-
tality rates will be higher, leading to a decline in the population growth rate;
i.e., n1 < n0 . However, since the population growth rate is still positive, the
population will continue to grow (although at a slower rate); i.e., N2 > N1 .
Again, referring to Figure 13.1, we see that the higher population continues to
put pressure on the land, leading to a further decline in living standards; i.e.,
y2 < y1 .
By applying this logic repeatedly, we see that per capita income will even-
tually (the process could take several years or even decades) converge to its
subsistence level; i.e., yt & y ∗ . At the same time, total GDP and population
will rise to higher ‘long run’ values; i.e., Yt % Y ∗ and Nt % N ∗ . These ‘long
run’ values are sometimes referred to as ‘steady states.’ Figure 13.3 depicts
these transition dynamics.
FIGURE 13.3
Transition Dynamics
Yt
f(Nt )
Y*
Yt0
Slope = y*
0 Nt0 N* Nt
n( yt )
nt0
0
y* yt0
• Exercise 13.1. Using a diagram similar to Figure 13.3, describe the

dynamics that result when the initial population is such that N0 > N ∗ .
13.3.3 Technological Progress in the Malthus Model

We know that Medieval Europe (800 - 1400 A.D.) did experience a considerable
amount of technological progress and population growth (e.g., the population
roughly doubled from 800 A.D. to 1300 A.D.). Less is known about how living
standards changed, but there appears to be a general view that at least moderate
improvements were realized.
We can model an exogenous technological advance (e.g., the invention of the
wheelbarrow) as an outward shift of the aggregate production function. Let us
assume that initially, the economy is in a steady state with living standards
equal to y ∗ . In the period of the technology shock, per capita incomes rise as
the improved technology makes the existing population more productive; i.e.,
y1 > y ∗ . However, since living standards are now above subsistence levels, the
population begins to grow; i.e., N1 > N0 . Using the same argument described
in the previous section, we can conclude that after the initial rise in per capita
income, living standards will gradually decline back to their original level. In
the meantime, the total population (and total GDP) expands to a new and
higher steady state.
• Exercise 13.2. Using a diagram similar to Figure 13.3, describe the dy-
namics that result after the arrival of a new technology. Is the Malthus
model consistent with the growth experience in Medieval Europe? Ex-
plain.
13.3.4 An Improvement in Health Conditions

The number one cause of death in the history of mankind has not been war,
but disease.2 Slowly, medical science progressed to the point of identifying the
primary causes of various diseases and recommending preventative measures
(such as boiling water). For example, during the 1854 Cholera epidemic in Lon-
don, John Snow (who had experienced the previous epidemics of 1832 and 1854)
became convinced that Cholera was a water-borne disease (caused by all the hu-
man waste and pollution being dumped into the Thames river). Public works
projects, like the Thames Embankment (which was motivated more by Parlia-
mentarians’ aversion to the ‘Great Stink’ emanating from the polluted Thames,
than by concerns over Cholera), led to greatly improved health conditions and
reduced mortality rates.
We can model a technological improvement in the ‘health technology’ as an
upward shift in the function n(yt ); i.e., a decline in the mortality rate associated
with any given living standard yt . Again, assume that the economy is initially
at a steady state y ∗ , depicted as point A in Figure 13.4. The effect of such a
change is to immediately reduce mortality rates which, according to Maltusian
reasoning, then leads to an increase in population. But as the population ex-
pands, the effect is to reduce per capita income. Eventually, per capita incomes
∗
fall to a new and lower subsistence level yN , depicted by point B in Figure 13.4.
2 Even during wars, most soldiers evidently died from disease rather than combat wounds.
For an interesting account of the role of disease in human history, I would recommend reading
Jared Diamond’s book Guns, Germs and Steel (1997).
That is, while the improved health conditions have the short run effect of low-
ering mortality rates, the subsequent decline in per capita reverses the effect so
that in the long run, people are even worse off than before!
FIGURE 13.4
An Improvement in Health Technology
nt
nH( yt )
A nL( yt )
B
0 yH* yL* yt
• Exercise 13.3. In 1347, the population of Europe was around 75 million.

In that year, the continent was ravaged by a bubonic plague (the Black
Death), which killed approximately 25 million people over a five year pe-
riod (roughly one-third of the population). The ensuing labor shortages
apparently led to a significant increase in real wages (per capita incomes),
although total output fell. Using a diagram similar to Figure 13.4, de-
scribe the dynamics for per capita income in the Malthusian model when
the economy is subject to a transitory increase in the mortality rate.
13.3.5 Confronting the Evidence

For most economies prior to 1800, growth in real per capita incomes were mod-
erate to nonexistent. Since 1800, most economies have exhibited at least some
growth in per capita incomes, but for many economies (that today comprise the
world’s underdeveloped nations), growth rates have been relatively low, leaving
their per capita income levels far behind the leading economies of the world.
The Maltusian model has a difficult time accounting for the sustained in-
crease in per capita income experienced by many countries since 1800, especially
13.4. FERTILITY CHOICE 275
in light of the sharp declines in mortality rates that have been brought about
by continuing advancements in medical science. It is conceivable that persistent
declines in the birth rate offset the declines in mortality rates (downward shifts
of the population growth function in Figure 13.2) together with the continual
appearance of technological advancements together could result in long periods
of growth in per capita incomes. But the birth rate has a lower bound of zero
and in any case, while birth rates do seem to decline with per capita income,
most advanced economies continue to exhibit positive population growth.
In accounting for cross-section differences in per capita incomes, the Malthu-
sian model suggests that countries with high population densities (owing to high
birth rates) will be those economies exhibiting the lowest per capita incomes.
One can certainly find modern day countries, like Bangladesh, that fit this de-
scription. On the other hand, many densely populated economies, such as Hong
Kong, Japan and the Netherlands have higher than average living standards. As
well, there are many cases in which low living standards are found in economies
with low population density. China, for example, has more than twice as much
cultivated land per capita as Great Britain or Germany.
At best, the Malthusian model can be regarded as giving a reasonable ac-
count of the pattern of economic development in the world prior to the Industrial
Revolution. Certainly, it seems to be true that the vast bulk of technological im-
provements prior to 1800 manifested themselves primarily in the form of larger
populations (and total output), with only modest improvements in per capita
incomes.
13.4 Fertility Choice

The Malthusian model does not actually model the fertility choices that house-
holds make. The model simply assumes that the husband and wife decide to
create children for really no reason at all. Perhaps children are simply the
by-product of uncontrollable passion or some primeval urge to propagate one’s
genetic material. Or perhaps in some cultures, men perceive that their status
is enhanced with prolific displays of fertility. Implicitly, it is assumed that the
fertility choices that people make are ‘irrational.’ In particular, some simple
family planning (choosing to reduce the birth rate) would appear to go a long
way to improving the living standards of future generations.
• Exercise 13.4. Suppose that individuals could be taught to choose the

birth rate according to: b(y) = m(y) (i.e., to produce just enough children
to replace those people who die). Explain how technological progress
would now result in higher per capita incomes.
While it is certainly the case that the family planning practices of some
households seem to defy rational explanation, perhaps it is going too far to
suggest that the majority of fertility choices are made largely independent of
economic considerations. In fact, it seems more likely to suppose that fertility
is a rational choice, even in lesser developed economies. A 1984 World Bank
report puts it this way (quoted from Razin and Sadka, 1995, pg. 5):
All parents everywhere get pleasure from children. But children in-
volve economic costs; parents have to spend time and money bring-
ing them up. Children are also a form of investment—providing short-
term benefits if they work during childhood, long-term benefits if
they support parents in old age. There are several good reasons
why, for poor parents, the economic costs of children are low, the
economic (and other) benefits of children are high, and having many
children makes economic sense.
Here, I would like to focus on the idea of children as constituting a form of

investment. What appears to be true of many primitive societies is a distinct
lack in the ability for large segments of society to accumulate wealth in the
form of capital goods or (claims to) land. Partly this was due to a lack of well-
developed financial markets and partly this was due to the problem of theft
(only the very rich could afford to spend the resources necessary to protect
their property). Given such constraints, in may well make sense for poorer
families to store their wealth through other means, for example, by investing
in children (although, children can also be stolen, for example, by conscription
into the military or by the grim reaper).
Let us try to formalize this idea by way of a simple model. Consider an
economy in which time evolves according to t = 0, 1, 2, ..., ∞. For simplicity,
assume that individuals live for two periods. In period one they are ‘young’
and in period two they are ‘old.’ Let ct (j) denote the consumption enjoyed
by an individual at period t in the j th period of life, where j = 1, 2. Assume
that individuals have preferences defined over their lifetime consumption profile
(ct (1), ct+1 (2)), with:
Ut = ln ct (1) + β ln ct+1 (2),
where 0 < β < 1 is a subjective discount factor. For these preferences, the mar-
ginal rate of substitution between time-dated consumption is given by M RS =
ct+1 (2)/(βct (1)).
Let Nt denote the number of young people alive at date t, so that Nt−1
represents the number of old people alive at date t. The population of young
people grows according to:
Nt+1 = nt Nt ,
where nt here is the gross population growth rate; i.e., the average number of
children per (young) family. Note that nt > 1 means that the population is
expanding, while nt < 1 means that the population is contracting. We will
assume that nt is chosen by the young according to some rational economic
principle.
Assume that only the young can work and that they supply one unit of labor
at the market wage rate wt . Because the old cannot work and because the have
no financial wealth to draw on, they must rely on the current generation of young
people (their children) to support them. Suppose that these intergenerational
transfers take the following simple form: The young set aside some fraction
0 < θ < 1 of their current income for the old. Since the old at date t have nt−1
children, the old end up consuming:
ct (2) = nt−1 θwt . (13.4)
This expression tells us that the living standards of old people are an increasing
function of the number of children they have supporting them. As well, their
living standards are an increasing function of the real wage earned by their
children.
Creating and raising children entails costs. Assume that the cost of nt chil-
dren is nt units of output. In this case, the consumption accruing to a young
person (or family) at date t is given by:
ct (1) = (1 − θ)wt − nt . (13.5)
By substituting equation (13.5) into equation (13.4), with the latter equation
updated one period, we can derive the following lifetime budget constraint for
a representative young person:
ct+1 (2)
ct (1) + = (1 − θ)wt . (13.6)
θwt+1
Equation (13.6) should look familiar to you. In particular, the left hand side
of the constraint represents the present value of lifetime consumption spending.
But instead of discounting future consumption by the interest rate (which does
not exist here since there are no financial markets), future consumption is dis-
counted by a number that is proportional to the future wage rate. In a sense,
the future wage rate represents the implicit interest rate that is earned from
investing in children today. Figure 13.5 displays the optimal choice for a given
pattern of wages (wt , wt+1 ).
FIGURE 13.5
Optimal Family Size
ct+1(2)
qwt+1(1 - q)wt
A
Slope = - qwt+1
0 (1 - q)wt ct(1)
D
nt
Figure 13.5 makes clear the analog between the savings decision analyzed
in Chapter 4 and the investment choice in children as a vehicle for saving in
the absence of any financial market. While having more children reduces the
living standards when young, it increases living standards when old. At point
A, the marginal cost and benefit of children are exactly equal. Note that the
desired family size generally depends on both current and future wages; i.e.,
nD D
t = n (wt , wt+1 ).
• Exercise 13.5. How does desired family size depend on current and
future wages? Explain.
We will now explain how wages are determined. Assume that the aggregate
production technology is given by (13.1). The fixed factor K, which we interpret
to be land, is owned by a separate class of individuals (landlords). Imagine that
landlords are relatively few in number and that they form an exclusive club (so
that most people are excluded from owning land). Landowners hire workers
at the competitive wage rate wt in order to maximize the return on their land
Dt = F (K, Nt ) − wt Nt . As in Appendix 2.A, the profit maximizing labor input
NtD = N D (wt ) is the one that just equates the marginal benefit of labor (the
marginal product of labor) to the marginal cost (the wage rate); i.e.,
M P L(N D ) = wt .
The equilibrium wage rate wt∗ is determined by equating the supply and demand
for labor; i.e.,
N D (wt∗ ) = Nt .
Alternatively, you should be able to show that the equilibrium wage rate can
also be expressed as: wt∗ = M P L(Nt ).
• Exercise 13.6. How does the equilibrium wage rate depend on the supply
of labor Nt ? Explain.
Mathematically, the general equilibrium of our model economy is character-

ized by the following condition:
Nt+1 = nD (wt∗ , wt+1
∗
)Nt
where wt∗ = M P L(Nt ), with Nt given as of period t. These expressions implicitly
defines a function n∗t = φ(Nt ).3 A stable steady state will exist if φ0 (N ) < 0, so
let us make this assumption here.4 This condition asserts that the equilibrium
population growth rate is a decreasing function of population size; see Figure
13.6.
FIGURE 13.6
Equilibrium Population Dynamics
nt
n0*
1.0
N0 N* Nt
f(Nt )
3 The function φ is defined implicitly by:
φ(Nt ) = nD (MP L(Nt ), MP L(φ(Nt )Nt ).
4 I am pretty sure that for sufficiently large populations, the function φ must eventually
decline with population since land is in fixed supply.

In Figure 13.6, the initial population of young people is given by N0 , which

results in population growth. In the subsequent period, N1 > N0 , which puts
added pressure on the limited supply of land (just as in the Malthusian model),
resulting in a decline in the equilibrium wage.5 Unlike the Malthusian model,
however, people here are making rational choices about family size. As the pop-
ulation expands, it is rational to reduce family size. Eventually, the population
reaches a steady state level N ∗ .
From the condition that characterizes optimal family size (Figure 9.5), the
steady state consumption levels must satisfy:
1 c∗ (1)
= θw∗ = θM P L(N ∗ ).
β c∗ (2)
Now, assume that the share parameter θ is chosen according to a principle of
‘long-run fairness,’ so that c∗ (1) = c∗ (2). Notice that this does not necessarily
imply that consumption is equated across generations during the transition to
a steady state; it only implies that consumption is equated in the steady state.
In this case, the equilibrium steady state population size (and wage rate) is
determined by:
1
M P L(N ∗ ) = = w∗ . (13.7)
θβ
Condition (13.7) tells us that the steady state population N ∗ is determined by
the nature of the production technology (M P L) and the nature of preferences
(β).
Now, beginning in some steady state, let us examine how this economy reacts
to a technology shock that improves production methods. The effect of the
shock is to increase the marginal product of labor at every level of employment
(so that the function φ in Figure 9.6 shifts upward). From equation (13.7),
we see that the initial effect of the shock is to increase the wage rate above
w∗ . A standard consumption-smoothing argument suggests that consumption
rises initially for both the young and old. The way that the initial young can
guarantee higher future consumption is by having more children (re: Exercise
9.5). The increasing population, however, puts downward pressure on the wage
until it eventually falls to its initial value w∗ . From equation (13.7), we see that
the long-run wage rate depends only on β and not on the nature of technology.
It follows, therefore, that the long-run living standards of those individuals who
must save by investing in children remains unaffected by technological progress.
The effect of technological progress on per capita income depends on the
breeding habits of landlord families and the relative importance of land versus
labor in the production process. If landlord family size remains constant over
time, then per capita income will rise since the shock increases the return to
land. But if land accounts for a relatively small fraction of total output, then
the impact on per capita GDP will be small.
5 As the future wage rate is expected to decline, the return to investing in children also
declines (the substitution effect) would further curtail the production of children.
13.4.1 Policy Implications

The basic point of this analysis is to show that what appears (to us) to be
irrational family planning may in fact be the consequence of rational choices
made by individuals who are prevented from saving through the accumulation
of financial assets or physical capital. The policy implications here differ quite
radically from those that one might deduce from the Malthusian model. In
particular, the Malthusian model suggests that a government program designed
to limit the breeding rate of peasants might be a good idea. An example of this
is the ‘one-child’ policy implemented by the Chinese government in 1980.6 In
contrast, the model developed in this section suggests that a better idea might
be to make participation in capital markets more accessible for the poor. Less
reliance on children to finance retirement living standards would imply lower
population growth rates and higher material living standards for all people.
6 http:// nhs.needham.k12.ma.us/ cur/ kane98/ kanep2/ chinas1kid/ dcva2.html

13.5 Problems
1. Many countries have implemented pay-as-you-go (PAYG) public pension
systems. A PAYG system taxes current income earnings (the young) and
transfers these resources to the initial old. Explain how such a system
could also serve to reduce population growth.
2. Many countries with PAYG pension systems are currently struggling with
the problem of population growth rates that are too low ; e.g., see: www.oecdobserver.org/
news/ fullstory.php/ aid/563/ Can_ governments_ influence_ popula-
tion_ growth_ .html, for the case of Sweden. Use the model developed
in this section to interpret this phenomenon.
3. Economists have advocated replacing the PAYG pension system with a
fully funded (FF) pension system. Whereas the PAYG system transfers
resources across generations (from the young to the old in perpetuity), the
FF system taxes the young and invests the proceeds in capital markets (so
that there are no intergenerational transfers). Does the FF system sound
like a good idea? Explain.
13.6 References
1. Diamond, Jared (1997). Guns, Germs and Steel: The Fates of Human
Societies, New York: W.W. Norton.
2. Godwin, William (1793). Enquiry Concerning Political Justice, http://
web.bilkent.edu.tr/ Online/www.english.upenn.edu /jlynch/ Frank/ God-
win/ pjtp.html
3. Jones, Eric L. (1981). The European Miracle, Cambridge: Cambridge
University Press.
4. Malthus, Thomas (1798). Essay on the Principle of Population, www.ac.wwu.edu/
~stephan/ malthus/ malthus.0.html
5. Mokyr, Joel (1990). The Levers of Riches: Technological Creativity and
Economic Progress, Oxford University Press, New York.
6. Razin, Assaf and Efraim Sadka (1995). Population Economics, The MIT
Press, Cambridge, Massachussetts.
Chapter 14
Modern Economic
Development
14.1 Introduction
In the previous chapter, we saw that despite the fact of technological progress
throughout the ages, material livings standards for the average person changed
relatively little. It also appears to be true that differences in material living
standards across countries (at any point in time) were relatively modest. For
example, Bairoch (1993) and Pomeranz (1998) argue that living standards across
countries in Europe, China, and the Indian subcontinent were roughly compara-
ble in 1800. Parente and Prescott (1999) show that material living standards in
1820 across the ‘western’ world and ‘eastern’ world differed only by a factor of
about 2. Overall, the Malthusian growth model appears to account reasonably
well for the pattern of economic development for much of human history.
But things started to change sometime in the early part of the 19th cen-
tury, around the time of the Industrial Revolution that was occurring (pri-
marily in Great Britain, continental Europe, and later in the United States).
There is no question that the pace of technological progress accelerated during
this period. The list of technological innovations at this time are legendary
and include: Watt’s steam engine, Poncelet’s waterwheel, Cort’s puddling and
rolling process (for iron manufacture), Hargeave’s spinning jenny, Crompton’s
mule, Whitney’s cotton gin, Wilkensen’s high-precision drills, Lebon’s gas light,
Montgolfiers’ hydrogen balloon, and so on. The technological innovations in the
British manufacturing sector increased output dramatically. For example, the
price of cotton declined by 85% between 1780 and 1850. At the same time, per
capita incomes in the industrialized countries began to rise measurably for the
first time in history.
285
286 CHAPTER 14. MODERN ECONOMIC DEVELOPMENT
It is too easy (and probably wrong) to argue that the innovations associated
with the Industrial Revolution was the ‘cause’ of the rise in per capita income
in the western world. In particular, we have already seen in Chapter 13 that
technological progress does not in itself guarantee rising living standards. Why,
for example, did the rapid pace of technological development simply not dissi-
pate itself entirely in the form of greater populations, consistent with historical
patterns?1 Clearly, something else other than just technological progress must
be a part of any satisfactory explanation.
As per capita incomes began to grow rapidly in countries that became in-
dustrialized (i.e., primarily the western world), living standards in most other
countries increased at a much more modest pace. For the first time in history,
there emerged a large and growing disparity in the living standards of people
across the world. For example, Parente and Prescott (1999) report that by 1950,
the disparity in real per capita income across the ‘west’ and the ‘east’ grew to
a factor of 7.5; i.e., see Table 14.1.
Table 14.1
Per Capita Income (1990 US$)
Year West East West/East
1820 1,140 540 2.1
1870 1,880 560 3.3
1900 2,870 580 4.2
1913 3,590 740 4.8
1950 5,450 727 7.5
1973 10,930 1,670 6.5
1989 13,980 2,970 4.7
1992 13,790 3,240 4.3
The data in Table 10.1 presents us with a bit of a puzzle: why did growth
in the east (as well as many other places on the planet) lag behind the west
for so many decades? Obviously, most of these countries did not industrialize
themselves as in the west, but the question is why not? It seems hard to believe
that people living in the east were unaware of new technological developments
or unaccustomed to technological progress. After all, as was pointed out in the
previous chapter, most of the world’s technological leaders have historically been
located in what we now call the east (the Moslem world, the Indian subcontinent,
China). At the same time, it is interesting to note that the populations in the
eastern world exploded over this time period (in accord with the Malthusian
model).
Some social scientists (notably, those with a Marxian bent) have laid the
blame squarely on the alleged exploitation undertaken by many colonial powers
(e.g., Great Britain in Africa). But conquest and ‘exploitation’ have been with
us throughout human history and has a fine tradition among many eastern
1 While populations did rise in the west, total income rose even faster.
14.1. INTRODUCTION 287
cultures too. So, perhaps one might ask why the east did not emerge as the
world’s colonial power?
In any case, it simply is not true that all eastern countries were under colonial
domination. For example, Hong Kong remained a British colony up until 1997
while mainland China was never effectively controlled by Britain for any length
of time. And yet, while Hong Kong and mainland China share many cultural
similarities, per capita incomes in Hong Kong have been much higher than on
the mainland over the period of British ‘exploitation.’ Similarly, Japan was
never directly under foreign influence until the end of the second world war.
Of course, this period of foreign influence in Japan happens to coincide with a
period of remarkable growth for the Japanese economy.
Table 14.1 reveals another interesting fact. Contrary to what many people
might believe, the disparity in per capita incomes across many regions of the
world appear to be diminishing. A large part of this phenomenon is attributable
to the very rapid growth experienced recently by economies like China, India
and the so-called ‘Asian tigers’ (Japan, South Korea, Singapore, Taiwan). So
again, the puzzle is why did (or have) only some countries managed to embark
on a process of ‘catch up’ while others have been left behind? For example,
the disparity in incomes across the United States and some countries in the
sub-Saharan African continent are still different by a factor of 30!
The ‘development puzzle’ that concerns us can be looked at also in terms of
countries within the so-called western world. It is not true, for example, that all
western countries have developed at the same pace; see, for example, Figure 14.1.
The same can be said of different regions within a country. For example, why are
eastern Canadian provinces so much poorer than those in central and western
Canada? Why is the south of Italy so much poorer than the north? Why is the
northern Korean peninsula so much poorer than the South (although, these are
presently separate countries)? In short, what accounts for the vast disparity in
per capita incomes that have emerged since the Industrial Revolution?
FIGURE 14.1
Real per Capita GDP Relative to the United States
Selected Countries
Western Europe Africa

100 100
Sweden
80 80
UK
60 France 60
Spain
South Africa
40 40
Algeria
20 20 Botswana
Ghana
0 0
50 55 60 65 70 75 80 85 90 95 00 50 55 60 65 70 75 80 85 90 95 00
Eastern Europe Asia

100 100
80 80 Japan
60 60
Hong Kong
Hungary
40 40
Russia
South Korea
Poland
20 20
Romania
India
0 0
50 55 60 65 70 75 80 85 90 95 00 50 55 60 65 70 75 80 85 90 95 00
Middle East Latin America

100 100
80 80
Argentina
60 60
Israel
40 Iran 40 Mexico
Syria Brazil
20 20
Colombia
Jordan
0 0
50 55 60 65 70 75 80 85 90 95 00 50 55 60 65 70 75 80 85 90 95 00
14.2. THE SOLOW MODEL 289
14.2 The Solow Model

The persistent rise in living standards witnessed in many countries and the large
disparity in per capita incomes across countries are facts that are difficult to
account for with the Malthusian model. For this reason, economists turned to
developing an alternative theory; one that would hopefully be more consistent
with recent observation. The main model that emerged in the mid-20th century
was the so-called Solow growth model, in honor of Robert Solow who formalized
the basic idea in 1956 (Solow, 1956). Keep in mind that, like the Malthusian
model, the Solow model does not actually explain why technological progress
occurs; i.e., it treats the level (and growth rate) of technology as an exogenous
variable. The name of the game here is see whether differences in per capita
incomes can be explained by (exogenous) technological developments (among
possibly other factors).
We remarked in Chapter 13 that China has much more cultivated land per
capita as Great Britain. But what then accounts for the higher standard of living
in Great Britain? One explanation is to be found in the fact that Great Britain
has considerably more railroads, refineries, factories and machines per capita.
In other words, Great Britain has more physical capital per capita (a higher
capital-labor ratio) relative to China (and indeed, relative to Great Britain 100
years ago). Of course, this does not answer the question of why Britain has
more physical capital than China. The model of endogenous fertility choices in
Chapter 9 suggests that one reason might be that the institutional environment
in China is (or was) such that the Chinese (like many lesser developed economies
in history) are restricted from accumulating physical or financial assets, so that
‘retirement saving’ must be conducted through family size.2
In any case, the Solow model is firmly rooted in the model developed in
Chapter 6, which assumes that individuals can save through the accumulation
of physical and/or financial assets. Now, unlike land, which is largely in fixed
supply (this is not exactly true, since new land can be cultivated), the supply
of physical capital can grow with virtually no limit by producing new capital
goods. Hence, the first modification introduced by the Solow model is the idea
that output is produced with both labor and a time-varying stock of physical
capital; i.e.,
Yt = F (Kt , Nt ), (14.1)
and that the capital stock can grow with net additions of new capital. Let Xt
denote gross additions to the capital stock (i.e., gross investment). Assuming
that the capital stock depreciates at a constant rate 0 ≤ δ ≤ 1, the net addition
to the capital stock is given by Xt − δKt , so that the capital stock evolves
according to:
Kt+1 = Kt + Xt − δKt . (14.2)
2 Of course, this does not explain why the institutional environments should differ the way
that they do.

Of course, by allocating resources in an economy toward the construction of

new capital goods (investment), an economy is necessarily diverting resources
away from the production (and hence consumption) of consumer goods and ser-
vices. In other words, individuals as a group must be saving. In the Malthus
model, individuals were modeled as being either unwilling or unable to save.
Perhaps this was a good description for economies prior to 1800, but is not a
good description of aggregate behavior since then. Thus, the second modifica-
tion introduced by the Solow model is the idea that a part of current GDP is
saved; i.e.,
St = σYt , (14.3)
where 0 < σ < 1 is the saving rate. In the Solow model, the saving rate is
viewed as an exogenous parameter. However, as we learned in Chapter 6, the
saving rate is likely determined by ‘deeper’ parameters describing preferences
(e.g., time preference) and technology.
The final modification made by the Solow model is in how it describes pop-
ulation growth. Unlike the Malthus model, which assumed that mortality rates
were a decreasing function of living standards, the Solow model simply assumes
that the population growth rate is determined exogenously (i.e., is insensitive
to living standards and determined largely by cultural factors). Consequently,
the population grows according to:
Nt+1 = (1 + n)Nt , (14.4)
where n denotes the net population growth rate.
We are now in a position to examine the implications of the Solow model.
We can start with the production function in (14.1), letting F (K, N ) = K 1−θ N θ
as we did earlier. As before, we can define per capita output yt ≡ Yt /Nt so that:
µ ¶1−θ
Kt
yt = ≡ f (kt ),
Nt
where kt ≡ Kt /Nt is the capital-labor ratio. Thus, per capita output is an
increasing and concave function of the capital-labor ratio (try drawing this).
By dividing the saving function (14.3) through by Nt , we can rewrite it in
per capita terms:
st = σyt ; (14.5)
= σf (kt ).
Now, take equation (14.2) and rewrite it in the following way:
Nt+1 Kt+1 Kt Xt δKt
= + − .
Nt+1 Nt Nt Nt Nt
Using equation (14.4), we can then express this relation as:
(1 + n)kt+1 = (1 − δ)kt + xt , (14.6)
where xt ≡ Xt /Nt .
In a closed economy, net saving must equal net investment; i.e., st = xt . We
can therefore combine equations (14.5) and (14.6) to derive:
(1 + n)kt+1 = (1 − δ)kt + σf (kt ). (14.7)
For any initial condition k0 , equation (14.7) completely describes the dynamics
of the Solow growth model. In particular, given some k0 , we can use equation
(14.7) to calculate k1 = (1 + n)−1 [(1 − δ)k0 + f (k0 )]. Then, knowing k1 , we
can calculate k2 = (+n)−1 [(1 − δ)k1 + f (k1 )], and so on. Once we know how
the capital-labor ratio evolves over time, it is a simple matter to calculate the
time-path for other variables since they are all functions of the capital-labor
ratio; e.g., yt = f (kt ).Equation (14.7) is depicted graphically in Figure 14.2.
FIGURE 14.2
Dynamics in the Solow Model
kt+1
450
(1+n)-1[ (1-d)kt + sf(kt)]
k*
k1
0 k0 k1 k2 k* kt
As in the Malthus model, we see from Figure 14.2 that the Solow model
predicts that an economy will converge to a steady state; i.e., where kt+1 =
kt = k ∗ . The steady state capital-labor ratio k∗ implies a steady state per capita
income level y ∗ = f (k ∗ ). If the initial capital stock is k0 < k ∗ , then kt % k ∗ and
yt % y ∗ . Thus, in contrast to the Malthus model, the Solow model predicts that
real per capita GDP will grow during the transition period toward steady state,
even as the population continues to grow. In the steady state, however, growth
in per capita income ceases. Total income, however, will continue to grow at
the population growth rate; i.e., Yt∗ = f (k ∗ )Nt .
Unlike the Malthus model, the Solow model predicts that growth in per
capita income will occur, at least in the ‘short run’ (possibly, several decades)
as the economy makes a transition to a steady state. This growth comes about
because individuals save output to a degree that more than compensates for the
depreciated capital and expanding population. However, as the capital-labor
ratio rises over time, diminishing returns begin to set in (i.e., output per capita
does not increase linearly with the capital-labor ratio). Eventually, the returns
to capital accumulation fall to the point where just enough investment occurs
to keep the capital-labor ratio constant over time.
The transition dynamics predicted by the Solow model may go some way to
partially explaining the rapid growth trajectories experienced over the last few
decades in some economies, for example, the ‘Asian tigers’ of southeast Asia
(see Figure 14.1). Taken at face value, the explanation is that the primary
difference between the U.S. and these economies in 1950 was their respective
‘initial’ capital stocks. While there may certainly be an element of truth to
this, the theory is unsatisfactory for a number of reasons. For example, based
on the similarity in per capita incomes across countries in the world circa 1800,
one might reasonably infer that ‘initial’ capital stocks were not very different in
1800. And yet, some economies industrialized, while others did not. Transition
dynamics may explain a part of the growth trajectory for those countries who
chose to industrialize at later dates, but it does not explain the long delay in
industrialization.
14.2.1 Steady State in the Solow Model
Because the level of income disparity has persisted for so long across many
economies, it may make more sense to examine the steady state of the Solow
model and see how the model interprets the source of ‘long-run’ differences in
per capita income. By setting kt+1 = kt = k ∗ , we see from equation (14.7) that
the steady state capital-labor ratio satisfies:
σf (k ∗ ) = (n + δ)k ∗ . (14.8)
Equation (14.8) describes the determination of k ∗ as a function of σ, n, δ and f.

Figure 10.3 depicts equation (14.8) diagrammatically.
FIGURE 14.3
Steady State in the Solow Model
f(k)
y*
c* (d+n)k
sf(k)
s*
0 k* k
According to the Solow model, exogenous differences in saving rates (σ),

population growth rates (n), or in technology (f ) may account for differences in
long-run living standards (y ∗ ). Of course, the theory does not explain why there
should be any differences in these parameters, but let’s leave this issue aside for
the moment.
14.2.2 Differences in Saving Rates
Using either Figure 14.2 or 14.3, we see that the Solow model predicts that
countries with higher saving rates will have higher capital-labor ratios and hence,
higher per capita income levels. The intuition for this is straightforward: higher
rates of saving imply higher levels of wealth and therefore, higher levels of
income.
Using a cross section of 109 countries, Figure 10.9 (mislabelled) plots the
per capita income of various countries (relative to the U.S.) across saving rates
(using the investment rate as a proxy for the saving rate). As the figure reveals,
there appears to be a positive correlation between per capita income and the
saving rate; a prediction that is consistent with the Solow model.
Figure 10.9 (Per Capita Incomes and Saving

Rates)
1.2
Per Capita Income
(Relative to U.S.)
1
0.8
0.6
0.4
0.2
0
0 0.1 0.2 0.3 0.4
Investment Rates
• Exercise 14.1. Consider an economy that is initially in a steady state.

Imagine now that there is an exogenous increase in the saving rate. Trace
out the dynamics for income and consumption predicted by the Solow
model. If the transition period to the new steady state was to take several
decades, would all generations necessarily benefit from the higher long-run
income levels?
• Exercise 14.2. According to the Solow model, can sustained economic

growth result from ever rising saving rates? Explain.
The deeper question here, of course, is why countries may differ in their
rate of saving. One explanation may be that savings rates (or the discount
factor in preferences) are ‘culturally’ determined. Explanations that are based
on ‘cultural’ differences, however, suffer from a number of defects. For example,
when individuals from many cultures arrive as immigrants to a new country, they
often adopt economic behavior that is more in line with their new countrymen.
As well, many culturally similar countries (like North and South Korea) likely
have very different saving rates (I have not checked this out). A more likely
explanation lies in the structure of incentives across economies. Some of these
incentives are determined politically, for example, the rate at which the return
to saving and investment is taxed. But then, the question simply turns to what
determines these differences in incentives.
14.2.3 Differences in Population Growth Rates

Again, using either Figure 14.2 or 14.3, we see that the Solow model predicts
that countries with relatively low population growth rates should enjoy relatively
high per capita incomes. This prediction is similar to the Malthusian prediction,
but different in an important way. In particular, the Malthusian model predicts
that countries with high population densities should have lower living standards,
while the Solow model makes no such prediction. That is, in the Solow model,
even high density populations can enjoy high income levels, as long as they
have a sufficient amount of physical capital. A higher population growth rate,
however, spreads any given level of capital investment more thinly across a
growing population, which is what accounts for their lower capital-labor ratios.
Using a cross section of 109 countries, Figure 10.10 (mislabelled) plots the per
capita income of various countries (relative to the U.S.) across population growth
rates. According to this figure, there appears to be a mildly negative correlation
between per capita income and the population growth rate; a prediction that is
also consistent with the Solow model.
Figure 10.10 (Per Capita Incomes and Population

Growth Rates)
1.2
Per Capita Income
(Relative to U.S.)
1
0.8
0.6
0.4
0.2
0
0 0.01 0.02 0.03 0.04 0.05
Population Growth Rate
Again, the deeper question here is why do different countries have different
population growth rates? According to the Solow model, the population growth
rate is exogenous. In reality, however, people make choices about how many
children to have or where to move (i.e., population growth is endogenous). A
satisfactory explanation that is based on differences in population growth rates

should account for this endogeneity.
14.2.4 Differences in Technology

Parente and Prescott (1999) argue that exogenous differences in savings rates
(and presumably population growth rates) can account for only a relatively
small amount of the income disparity observed in the data. According to these
authors, the proximate cause of income disparity is attributable to differences in
total factor productivity (basically, the efficiency of physical capital and labor).
In the context of the Solow model, we can capture differences in total factor
productivity by assuming that different economies are endowed with different
technologies f.
For example, consider two economies A and B that have technologies f A (k)
and f B (k), where f A > f B for all values of k. You can capture this difference
by way of a diagram similar to Figure 14.3. Since the more productive economy
can produce more output for any given amount of capital (per worker), national
savings and investment will be higher. This higher level of investment translates
into a higher steady state capital labor ratio. Per capita output will be higher in
economy A for two reasons: First, it will have more capital (relative to workers);
and second, it is more productive for any given capital-labor ratio.
Differences in the production technology f across countries can be thought
of as differences in the type of engineering knowledge and work practices imple-
mented by individuals living in different economies. Differences in f might also
arise because of differences in the skill level or education of workers across coun-
tries. But while these types of differences might plausibly lead to the observed
discrepancy in material living standards around the world, the key question
remains unanswered: Why don’t lesser developed economies simply adopt the
technologies and work practices that have been so successful in the so-called
developed world? Likewise, this theory does not explain why countries that
were largely very similar 200 years ago are so different today (in terms of living
standards).
14.3 The Politics of Economic Development

Perhaps more headway can be made in understanding the process of economic
development by recognizing the politics that are involved in implementing new
technologies and work practices. By ‘politics’ I mean the conflict that appears
to arise among ‘different’ groups of people and the various methods by which
people in conflict with one another use to try to protect themselves and/or harm
others for private gain.
One thing that we should keep in mind about technological improvement
14.3. THE POLITICS OF ECONOMIC DEVELOPMENT 297
is that it rarely, if ever, benefits everyone in an economy in precisely the same

way. Indeed, some technological improvements may actually end up hurting
some segments of the economy, even if the economy as a whole benefits in some
sense. Whether a particular technological improvement can be implemented or
not likely depends to some extent on the relative political power of those special
interests that stand to benefit or lose from the introduction of a new technology.
If the political power of the potential losers is strong enough, they may be able
to erect laws (or vote for political parties that act on their behalf) that prevent
the adoption of a new technology.
14.3.1 A Specific Factors Model
Consider an economy populated by three types of individuals: capitalists, landown-

ers, and laborers. All individuals have similar preferences defined over two con-
sumer goods (c1 , c1 ). For simplicity, let the utility function be u(c1 +c2 ) = c1 +c2 .
With this assumption, the relative price of the two goods is fixed at unity (so
that they are perfect substitutes).
Capitalists are endowed with a fixed amount of physical capital K. Landown-
ers are endowed with a fixed amount of land capital L. there are N laborers,
each of whom are endowed with one unit of human capital. The two goods are
produced according to the following technologies:
Y1 = F (K, N1 );
Y2 = G(L, N2 );
where Nj represents the number of workers employed in sector j. Assume that F

and G are regular neoclassical production functions. Notice that Y1 is produced
with capital and labor, while Y2 is produced with land and labor. In this model,
capital and land are factors of production that are specific to a particular sector.
Labor is used in the production of both goods (so you can think of labor as a
general factor of production). Assume that labor is freely mobile across sectors.
Let Fn and Gn denote the marginal product of labor associated with each
production function. Since F and G are neoclassical production functions, Fn
and Gn are positive and declining in the labor input (i.e., there are diminishing
returns to labor, given a fixed capital stock). In a competitive economy, labor
is paid its marginal product. If labor is mobile across sectors, then the sectoral
composition of employment will adjust to the point Fn (K, N1∗ ) = Gn (L, N2∗ ),
with N1∗ +N2∗ = N. Figure 10.4 displays the general equilibrium of this economy.
FIGURE 14.4
General Equilibrium
Specific Factors Model
MPL1 MPL2
Return to
Land
Return to
Capital
w*
Gn(L ,N-N1 )
Fn(K ,N1 )
0 N1* N
The triangular regions in Figure 14.4 represent the total returns to the spe-
cific factors. The rates of return accruing to each specific factor need not be
equated, since these factors are, by assumption, immobile. The total return to
labor is given by w∗ N, with each worker earning the return w∗ . In equilibrium,
each worker is indifferent between which sector to work in, since each sector
pays the same wage rate. To see why both sectors pay the same wage, suppose
that they did not. For example, imagine that w1 > w2 . Then workers in sector
2 would flock to sector 1, leading to an increase in N1 (and a corresponding
decline in N2 ). But as N1 expands, the marginal product of labor must fall in
sector 1. Likewise, as N2 contracts, the marginal product of labor in sector 2
must rise. In equilibrium, both sectors must pay the same wage.
Now, let us suppose that the capitalists of this economy realize that there
is some better technology out there F 0 for producing the output Y1 . The effect
of implementing this new technology is similar to the effect of a positive pro-
ductivity shock studied in earlier chapters. The new technology has the effect
of increasing the marginal product of labor at any given employment level N1 .
Imagine that the new technology shifts the M P L1 up, making it steeper, as in
Figure 14.5.
Point A in Figure 14.5 depicts the initial equilibrium and point B depicts
the new equilibrium. Notice that the new technology implemented in sector 1
has led to an increase in the wage in both sectors. The economic intuition for
this is as follows. Since the new technology improves the marginal product of
labor in sector 1, the demand for sector 1 workers increases. The increase in
FIGURE 14.5
A Sector-Specific Technology Shock
MPL1 MPL2
B
Dw* A
Gn(L ,N-N1 ) Fn’(K ,N1 )

Fn(K ,N1 )
0 N
DN1*
demand for labor puts upward pressure on the real wage, which attracts sector
2 workers to migrate to sector 1. Once again, in equilibrium, the wage must
be equated across sectors so that any remaining workers are just indifferent
between migrating or staying at home.
The new technology also increases the return to capital, since the new tech-
nology makes both capital and labor more productive. However, note that the
increase in the economy-wide wage rate reduces the return to land. This is be-
cause the new technology does not increase the efficiency of production in sector
2. Yet, sector 2 landowners must pay their labor a higher wage, increasing their
costs and hence lowering their profit.
The political economy implications of this simple model are rather straight-
forward. If landowners (in this example) wield enough political power, they
may be able to ‘block’ the implementation of the superior technology. While
per capita incomes will be lower as a result, their incomes will be spared the
adverse consequences of a new technology that serves to reduce the value of
their endowment (land, in this example).
• Exercise 14.3. Re-examine the specific factors model described above by

assuming that the two fixed factors constitute ‘high-skill’ and ‘low-skill’
labor, with a freely mobile factor (capital) that is used in both sectors of
the economy. Explain how a skill-biased technological advance may harm
low-skill workers. Now imagine that low-skill workers are highly organized
(represented by strong unions) and explain the pressure that politicians
may face to ‘regulate’ the adoption of the new technology. What other
ways may such workers be compensated?
14.3.2 Historical Evidence
It is important to realize that barriers emanating from special interests have

always been present in all economies (from ancient to modern and rich to poor),
so that any differences are really only a matter of degree. For example, as early
as 1397, tailors in Cologne were forbidden to use machines that pressed pinheads.
In 1561, the city council of Nuremberg, apparently influenced by the guild of
red-metal turners, launched an attack on Hans Spaichl who had invented an
improved slide rest lathe. The council first rewarded Spaichl for his invention,
then began to harass him and made him promise not to sell his lathe outside his
own craft, then offered to buy it from if he suppressed it, and finally threatened
to imprison anyone who sold the lathe. The ribbon loom was invented in Danzig
in 1579, but its inventor was reportedly secretly drowned by the orders of the
city council. Twenty five years later, the ribbon loom was reinvented in the
Netherlands (and so became known as the Dutch loom), although resistance
there too was stiff. A century and a half later, John Kay, the inventor of the
flying shuttle, was harassed by weavers. He eventually settled in France, where
he refused to show his shuttle to weavers out of fear. In 1299, an edict was
issued in Florence forbidding bankers to use Arabic numerals. In the fifteenth
century, the scribes guild of Paris succeeded in delaying the introduction of the
printing press in Paris by 20 years. In the sixteenth century, the great printers
revolt in France was triggered by labor-saving innovations in the presses.
Another take on the special interest story pertains to case in which the
government itself constitutes the special interest, as in the case of autocratic
rulers. It seems as a general rule, weaker governments are able to exert less
resistance to technological adoption. With some notable exceptions, autocratic
rulers have tended to be hostile or indifferent to technological change. Since
innovators are typically nonconformists and since technological change typically
leads to disruption, the autocrat’s instinctive desire for stability and suspicion
of nonconformism could plausibly have outweighed the perceived gains to tech-
nological innovation. Thus, in both the Ming dynasty in China (1368—1644)
and the Tokugawa regime in Japan (1600—1867) set the tone for inward-looking,
conservative societies. Only when strong governments realized that technologi-
cal backwardness itself constituted a threat to the regime (e.g., post 1867 Japan
and modern day China) did they intervene directly to encourage technological
change.
During the start of the Industrial Revolution in Britain, the political system
strongly favored the winners over the losers. Perhaps this was because the
British ruling class had most of its assets in real estate and agriculture which, if
anything, benefited from technological progress in other areas (e.g., by increasing

land rents). However, even in Britain, technological advances were met by
stiff opposition. For example, in 1768, 500 sawyers assaulted a mechanical saw
mill in London. Severe riots occurred in Lancashire in 1779, and there many
instances of factories being burned. Between 1811 and 1816, the Midlands and
the industrial counties were the site of the ‘Luddite’ riots, in which much damage
was inflicted on machines. In 1826, hand-loom weavers in a few Lancashire towns
rioted for three days. Many more episodes like these have been recorded.
But by and large, these attempts to prevent technological change in Britain
were unsuccessful and only served to delay the inevitable. An important rea-
son for this is to be found in how the government responded to attempts to
halt technological progress. In 1769, Parliament passed a harsh law in which
the wilful destruction of machinery was made a felony punishable by death. In
1779, the Lancashire riots were suppressed by the army. At this time, a res-
olution passed by the Preston justices of peace read: “The sole cause of the
great riots was the new machines employed in cotton manufacture; the country
notwithstanding has greatly benefited by their erection and destroying them in
this country would only be the means of transferring them to another...to the
great detriment of the trade of Britain.”
The political barriers to efficiency manifest themselves in many ways, from
trade restrictions and labor laws to regulatory red tape. For example, a recent
World Bank report (Doing Business in 2004: Understanding Regulation) docu-
ments the following. It takes two days to register a business in Australia, but
203 days in Haiti. You pay nothing to start a business in Denmark, while in
Cambodia you pay five times the country’s average income and in Sierra Leone,
you pay more than 13 times. In more than three dozen countries, including Hong
Kong, Singapore and Thailand, there is no minimum on the capital required by
someone wanting to start a business. In Syria, the minimum is 56 times the
average income; in Ethiopia and Yemen, it’s 17 times and in Mali, six. You can
enforce a simple commercial contract in seven days in Tunisia and 39 days in the
Netherlands, but in Guatemala it takes more than four years. The report makes
it clear, however, that good regulation is not necessarily zero regulation. The
report concludes that Hong Kong’s economic success, Botswana’s stellar growth
performance and Hungary’s smooth transition (from communism) have all been
stimulated by a good regulatory environment. Presumably, a ‘good’ regulatory
environment is one which allows individuals the freedom to contract while at the
same time providing a legal environment that protects private property rights
While there are certainly many examples of special interests working against
the implementation of better technology, our political economy story is not
without shortcomings. In particular, special interest groups are busy at work
in all societies. The key question then is why different societies confer more
or less power to various special interests. Perhaps some societies, such as the
United States, have erected institutions that are largely successful at mitigating
the political influence of special interests. These institutions may have been
erected at a time when a large part of the population shared similar interests
(e.g., during the American revolution).
But even if new technologies have sectoral consequences for the economy, it
is still not immediately clear why special interests should pose a problem for the
way an economy functions. For example, in the context of the model developed
above, why do individuals not hold a diversified portfolio of assets that would to
some extent protect them from the risks associated with sector-specific shocks?
In this way, individuals who are diversified can share in the gains of technological
progress. Alternatively (and perhaps equivalently), why do the winners not
compensate (bribe) the losers associated with a technological improvement?
These and many other questions remain topics of current research.
14.4 Endogenous Growth Theory
To this point, we have assumed that technological progress occurs exogenously.

The models developed to this point have concentrated on economic behavior
given the nature of the technological frontier and how it evolves over time. But
now it is time to think about what determines this frontier and its development
over time. The large literature that has emerged recently to deal with this
question is called endogenous growth theory and was spawned largely through
the work of Paul Romer (1986, 1994).
While the Solow model is useful for thinking about the determinants of the
level of long-run living standards, it is not capable (or designed to) explain
the determinants of long-run growth rates (although the model is capable of
explaining the short-run dynamics toward a steady state). In the absence of
technological progress, growth in per capita income must eventually approach
zero. The reason for this is to be found in the fact (or assumption) that capital
accumulation is subject to diminishing returns.
But now let us think of knowledge itself as constituting a type of capital
good. Unlike physical capital goods (or any other physical input), there are no
obvious limitations to the expansion of knowledge. Romer has argued that the
key feature of knowledge capital is its nonrivalrous nature. A good is said to be
rivalrous if its use by one person excludes its use by someone else. For example,
if I use a lawnmower to cut my lawn, this precludes anyone else from using my
lawnmower to cut their lawn at the same time. Knowledge, on the other hand,
is a different matter. For example, if I use a theorem to prove a particular result,
this does not preclude anyone else from using the same theorem at the same time
for their own productive purposes. Because of the nonrival nature of technology,
there are no obvious diminishing returns from knowledge acquisition.
14.4. ENDOGENOUS GROWTH THEORY 303
14.4.1 A Simple Model

Let zt denote the stock of ‘knowledge capital’ available at date t, for t =
1, 2, ..., ∞. Output per capita is given by the production function yt = zt f (kt ).
For simplicity, let us assume a constant population and a constant stock of phys-
ical capital and normalize units such that f (k) = 1. In this case, we have yt = zt .
What this says is that per capita output will grow linearly with the stock of
knowledge. In other words, there are constant returns to scale in knowledge
acquisition.
The economy is populated by two-period-lived overlapping generations, who
has preferences defined over sequences of consumption (ct (j)) and leisure (l),
Ut = ln(ct (1)) + v(l) + β ln(ct+1 (2))
where 0 < β < 1 is an exogenous time-preference parameter and v is an in-

creasing and strictly concave function. Here, ct (j) represents the consumption
of an individual in period t in the j th period of life. For these preferences, the
marginal rate of substitution between current leisure (l) and future consumption
(ct+1 ) is given by:
ct+1 (2)v 0 (l)
M RS(l, ct+1 (2)) = .
β
As well, the marginal rate of substitution between consumption at two different
points in time is given by:
1 ct+1 (2)
M RS(ct (1), ct+1 (2)) = .
β ct (1)
Young Individuals are endowed with two units of time and old individuals
are endowed with one unit of time. One unit of this time is used (exogenously)
in production, which generates yt = zt units of output. In a competitive labor
market, zt would also represent the equilibrium real wage. Output is nonstorable
(the physical capital stock cannot be augmented), so that ct (1) = yt = zt and
ct+1 (2) = yt+1 = zt+1 . The remaining unit of time for young individuals can be
used in one of two activities: leisure (l) or learning effort (e). Thus, individuals
are faced with the time constraint:
e + l = 1. (14.9)
Learning effort can be thought of the time spent in R&D activities. While
diverting time away from leisure is costly, the benefit is that learning effort
augments the future stock of knowledge capital. We can model this assumption
in the following way:
zt+1 = (1 + e)zt . (14.10)
Observe that e = 0 implies that zt+1 = zt and that e > 0 implies zt+1 > zt . In
fact, e represents the rate of growth of knowledge (and hence the rate of growth
of per capita GDP).
Since ct (1) = zt and ct+1 (2) = zt+1 , we can combine equations (14.10) and
(14.9) to form a relationship that describes the trade off between current leisure
and future consumption:
ct+1 (2) = (2 − l)zt . (14.11)
This constraint tells us that if l = 1 (so that e = 0), then ct+1 (2) = zt = ct (1)
(consumption will remain the same). On the other hand, if l = 0 (so that e = 1),
then ct+1 (2) = 2zt = 2ct (1) (consumption will double from this period to the
next). In general, individuals will choose some intermediate level of l (and hence
e) such that the marginal cost and benefit of learning effort is just equated. In
other words,
ct+1 (2)v 0 (l)
= zt . (14.12)
β
Conditions (14.12) and (14.11) are depicted in Figure 14.6.
FIGURE 14.6
Equilibrium Growth Rate
ct+1
2zt
zt+1* Slope = -zt
zt
0 lt* 1.0 lt
e t*
Notice that since ct+1 (2) = zt+1 , we can rewrite condition (14.12) as:
µ ¶
zt 1
v 0 (l) = β =β ,
zt+1 1+e
or, µ ¶
1
v 0 (1 − e∗ ) = β . (14.13)
1 + e∗
Equation (14.13) is one equation in the one unknown, e∗ . Thus, this condition
can be used to solve for the equilibrium growth rate e∗ . The left hand side
of equation (14.13) can be thought of as the marginal utility cost of learning
effort. Since v is strictly increasing and concave in leisure, increasing e (reducing
leisure) increases the marginal cost of learning effort. The right hand side of
equation (14.13) can be thought of as the marginal utility benefit of learning
effort. An increase in learning effort increases future consumption, but since u
is concave, the marginal benefit of this extra consumption falls with the level of
consumption. Figure 14.7 displays the solution in (14.13) with a diagram. The
equilibrium steady state growth rate is determined by the condition that the
marginal cost of learning effort is just equated with the marginal benefit; i.e.,
point A in Figure 14.7.
FIGURE 14.7
Steady State Growth Rate
Marginal
Benefit
and Cost v’(1 - e )
Marginal
Cost
A Marginal
Benefit
b(1 + e )-1
0 e* 1.0 e
Note that for the specification of preferences that we have assumed, the
equilibrium growth rate does not depend on zt .
• Exercise 14.4. Using a diagram similar to Figure 14.6, show how it is

possible for an increase in zt not to affect the equilibrium growth rate.
Provide some economic intuition.
With e∗ determined in this manner, the equilibrium growth rate in per capita
GDP is given by (yt+1 /yt ) = (1 + e∗ ). Note that long-run growth is endogenous
in this model because growth is not assumed (instead, we have derived this
property from a deeper set of assumptions). In particular, note that zero growth
is feasible (for example, by setting e∗ = 0). In general, however, individuals will
find it in their interest to choose some positive level of e∗ .
Finally, note that we can derive an expression for the equilibrium real rate of
interest in this economy. Since the marginal rate of substitution between time-
dated consumption is given by M RS = ct+1 /(βct ), we can use what we learned
in Chapter 6 by noting that the desired consumption profile must satisfy:
ct+1
= Rt ,
βct
where Rt is the (gross) real rate of interest (which is earned on or paid for risk-
free private debt). Because this is a closed endowment economy, we know that
the interest rate must adjust to ensure that desired national savings is equal to
zero. In other words, it must be the case that c∗t = zt for every date t. Thus, it
follows that:
1
R∗ = (1 + e∗ ). (14.14)
β
14.4.2 Initial Conditions and Nonconvergence

Now, let us consider two economies that are identical to each other in every
way except for an initial condition z1 . For example, suppose that z1A > z1B , so
that economy A is initially richer than economy B. Furthermore, assume that
each economy remains closed to international trade and knowledge flows (so
that economy B cannot simply adopt z1A ). Then our model predicts that these
two economies will grow at exactly the same rate (see Exercise 14.4). In other
words, economy A will forever be richer than economy B; i.e., the levels of per
capita GDP will never converge. Note that this result is very different than the
prediction offered by the Solow model, which suggests a long-run convergence
of growth rates (to zero).
Some economists have proposed this type of explanation for the apparent
lack of convergence in per capita GDP across many countries. In Figure 10.1,
for example, we see that many countries (in this sample) are growing roughly
at the same rate as the world’s technological leader (the United States).3
As with many models, there is probably an element of truth to this story. But
the theory also has its challenges. For example, I noted in the introduction that
according to our best estimates, the ‘initial conditions’ around the world c. 1800
were not that different. On the other hand, even very small differences in initial
conditions can manifest themselves as very large differences in levels over an
extended period of time. But then again, what might explain the fact that some
countries have managed to grow much faster than the U.S. for prolonged periods
of time? Perhaps this phenomenon was due to an international flow of knowledge
3 Remember that since Figure 10.1 plots a country’s per capita GDP relative to the U.S.,
a ‘flat’ profile indicates that the country is growing at the same rate as the U.S.
that allowed some countries to ‘catch up’ to U.S. living standards. A prime
example of this may be post war Japan, which very quickly made widespread
use of existing U.S. technology. Similarly, growth slowdowns may be explained
by legal restrictions that prevent the importation of new technologies. At the
end of the day, the million dollar question remains: Why do lesser developed
countries not do more to encourage the importation of superior technologies?
In other words, why don’t countries simply imitate the world’s technological
leaders?
14.5 References
1. Bairoch, P. (1993). Economics and World History: Myths and Paradoxes,
New York: Harvester-Wheatsheaf.
2. Parente, Stephen L. and Edward C. Prescott (1999). “Barriers to Riches,”
Third Walras-Pareto Lecture, University of Lausanne.
3. Pomeranz, K. (1998). “East Asia, Europe, and the Industrial Revolution,”
Unpublished Ph.D. Thesis, University of California (Irvine).
4. Romer, Paul M. (1986). “Increasing Returns and Long-Run Growth,”
Journal of Political Economy, 94: 1002—1037.
5. Romer, Paul M. (1994). “The Origins of Endogenous Growth,” Journal
of Economic Perspectives, 8: 3—22.
6. Solow, Robert M. (1956). “A Contribution to the Theory of Economic
Growth,” Quarterly Journal of Economics, 70: 65—94.

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Macroeconomic Theory and

I Macroeconomic Theory: Basics 1

2 Basic Neoclassical Theory 21

4 Consumption and Saving 67

5 Government Spending and Finance 111

5.5.1 A Transitory Increase in Government Spending . . . . . . 118

6 Capital and Investment 127

7 Labor Market Flows and Unemployment 147

II Macroeconomic Theory: Money 165

8.3.3 Government Money . . . . . . . . . . . . . . . . . . . . . 173

9 The New-Keynesian View 189

10 The Demand for Fiat Money 209

11 International Monetary Systems 227

12 Money, Capital and Banking 251

III Economic Growth and Development 261

14 Modern Economic Development 285

when viewed from the perspective of modern macroeconomic theory.

The Gross Domestic

Definition: The NDP is defined as the GDP less capital consumption.

1.2 How GDP is Calculated

Statistical agencies typically estimate an economy’s GDP in two ways: the

1.2.1 The Income Approach

United States Canada

Wage Income Wage Income

1.2.2 The Expenditure Approach

United States Canada

1.2.3 The Income-Expenditure Identity

Note that since the income-expenditure identity is an identity, it always

1.3 What GDP Does Not Measure

1.4 Nominal versus Real GDP

commonly adopted by statistical agencies. Consider an economy that produces

1.5 Real GDP Across Time

United States Canada

1997 CDN$ Per Annum

issue of long-run growth is called growth theory. A closely related branch of

1.6 Schools of Thought

imperfect information in financial markets.

3. The residential capital stock produces a flow of output in the form of

5. Explain why ‘overpaid’ government employees will lead to an overstate-

1.A Measured GDP: Some Caveats

twofold. First, one thing that characterizes underdeveloped economies is lack

The government sector produces output YG . Measuring the value of YG ,

If we add up private-sector and government-sector income (the previous two

In other words, it is assumed that the value of what is produced by government

Basic Neoclassical Theory

In this chapter, we develop a simple theory (based on the neoclassical perspec-

2.2 The Basic Model

2.2.1 The Household Sector

Households are assumed to have transitive preferences. That is, if a house-

The M RS has an important economic interpretation. In particular, it mea-

This constraint makes it clear that an increase in l necessarily entails a reduction

Choose (c, l) to maximize u(c, l) subject to: c = w − wl.

• Exercise 2.1. Using a diagram similar to Figure 2.2, identify an alloca-

Substitution and Wealth Eﬀects Following a Wage Change

(SE > WE)

• Exercise 2.2. Consider the utility function u(c, l) = ln c + λ ln l, where

• Exercise 2.3. Consider two household’s that have preferences as in the

2.2.2 The Business Sector

Choose (n) to maximize (z − w)n subject to 0 ≤ n ≤ 1.

where n in the expression above is any number in between 0 and 1. In words,